Tactical Short Strategy Conference Call – October 28, 2021
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
2021 Third-Quarter Recap
Conference Call with David McAlvany and Doug Noland
October 28, 2021
MWM Q3 2021 Tactical Short Conference Call
October 28, 2021
All right. We’ll go ahead and get started. Glad you could join us today. There’ll still be some folks trickling in, but we’ll get off and running. For those of you have questions as we go, feel free to jot them down. Go to our wealth management website, which is mwealthm.com. In the bottom right hand corner you’ll see a small chat box, and you can type in a question there. What we’ll do is wait until the tail end of our formal notes and then go through a Q&A. So I’ll begin with performance this afternoon, and then Doug will have some market comments. The focus today will be the Chinese credit markets and contagion, and then we’ll get in and circle back around to Q&A. So as something crosses your mind, if you want clarification, want us to expand on something, or perhaps we didn’t cover an area of interest to you, if it’s in our areas of expertise or ability, we’ll certainly do our best to answer it. Just feel free to put that into the chat function there on the wealth management website. Again, mwealthm.com.
So a formal good afternoon. We appreciate your participation in our third quarter 2021 recap conference call, and as always a special thank you to our valued account holders. We greatly value our client relationships. With a number of first timers listening today I want to begin with some general information, again, this is for those who are unfamiliar with Tactical Short. So bear with me those of you who’ve heard this before, but more detailed information is available at mwealthm.com/tacticalshort. And I’m available and Doug is available to answer questions offline. Look forward to working with you in some capacity. If you’re considering Tactical Short as an addition to your approach to the markets, long and short, hedging risks that you have elsewhere could be a great addition to your existing team or framework.
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 extra ordinary uncertainty and extreme risk. So the strategy is designed for separately managed accounts. And that structure allows for a very investor friendly format with full transparency, with flexibility, with reasonable fees and no lockups. We have the flexibility to short stocks, to short ETFs. And we also plan on occasion to buy liquid listed put options.
Shorting entails a unique set of risks. Some of which were further illuminated during this quarter. And I think one of the things that sets us apart is the analytical framework. The uncompromising focus on identifying and managing risk, which is an imperative if you’re going to be in the stock market at all, but certainly if you’re managing on the short side. Risk management is not optional.
Our Tactical Short strategy began the quarter with a short exposure targeted at 68%. And the short target was increased somewhat, ending the quarter at 70%, and due to the highly elevated risk environment for shorting, the S&P 500 ETF was, again, the only short position during the quarter. Our view is that taking aggressive bets against the stock market is ill advised. We never recommend in placing aggressive bets against the stock market. Especially in today’s extraordinary environment. We highlight this message during every call by saying this: Remaining a hundred percent short all the time, as most short products are structured, is risk indifference. The market rally over the past six quarters has inflicted huge losses on the short side for those indifferent to risk. And we believe a disciplined risk management is absolutely essential for long-term success. So we’ve structured Tactical Short to ensure the flexibility to navigate through even the most challenging market conditions.
So an update on performance. Tactical Short accounts after fees returned -0.53, negative half percent, during the third quarter, the S&P returned to +0.58. As for one-year performance, Tactical Short, after fees, returned, this is the one year number again, returned to -17.86% versus the +29.99 return for the S&P 500. So over the past year, Tactical Short accounts lost 60% of the S&P’s return. We regularly track Tactical Short performance versus three actively managed short fund competitors. First, the Grizzly Short Fund, which returned 2% during the Q3. For the past year Grizzly has returned a -33.92%. Ranger Equity Bear Fund returned 11.88% for the quarter, a positive quarter, but still over the last year, for the last four quarters, -42.74%. Federated Prudent Bear returned a -1.77% during Q3 and a -23.05% for the past year, while underperforming two of the three funds during the quarter, Tactical Short on average outperforms the competitors by 1,537 basis points over the past year.
On average, the three competitor funds lost 111% of the S&P’s 29.98% on that one-year basis. Tactical Short has also significantly outperformed each of the bear funds since inception from the April 7th, 2017 inception through the end of September. Tactical Short is at -38% versus the 98.44% return for the S&P in that same timeframe. And again, compared to the three competitors mentioned, an average outperformance of 2,723 basis points.
There are as well the popular passive short index products. The Tactical Short, again, outperformed the ProShares Short, which is the S&P 500 ETF. It lost 1.04% for the quarter and 25.05% for the past year. The Rydex Inverse S&P 500 Fund lost 1.11% during the quarter. And again, 25.05% of over four quarters. There’s also the PIMCO StocksPLUS® Short Fund, which returned -23 basis points and -21.51 for the quarter and past year. That’s what I’ve got for performance. Again, we’ll come back around to questions towards the tail end, feel free to put those in the chat function on the MwealthM website. And thank you again for joining us. Doug, over to you.
Thanks, David. Good afternoon, everyone. Thank you so much for taking time out of your busy day to be with us here. We’re living in a historic period, and it was yet another extraordinary quarter. Before I dive into the macro analysis, I’ll begin with some comments on performance and positioning, including a discussion of short exposure rebalancing. Let me start by explaining our underperformance versus two competitors. The broader market underperformed the S&P 500 during the quarter. For example, the Small-cap Russell 2000 declined 4.36% during Q3, with the average stock Value Line Arithmetic Index falling 3.13. The Grizzly Short Fund typically shorts smaller company stocks and the fund captured some of the broader market decline during the quarter. The Ranger Equity Bear Fund posted a strong quarter, benefiting from abrupt underperformance within the short stock universe. The Goldman Sachs Most Short Index dropped 12.06% during Q3, interrupting what had been a period of dramatic outperformance.
The problem on the short side is that if you dig a big performance hole, it becomes quite a challenge to climb out of it. Despite Ranger Equity Bear Fund’s positive quarter, it nonetheless posted a one-year loss of almost 43%. Tactical Short, again, outperform the Prudent Bear Fund along with the ProShares Short S&P 500 fund and the Rydex Inverse S&P 500 Fund. It’s typical for overall market strength, so-called breadth, to narrow during the topping process. I recall mentioning last quarter that I had expected Tactical Short might underperform as a broader market weakened relative to the S&P 500. While I was tempted to shift some short exposure into the broader market, in the end I did not view the risk versus reward of broader market exposure compelling in the current environment.
While narrowing breadth is a normal dynamic of topping processes, there is as well the typical wild volatility in the sector rotations that poses major challenges on the short side because of the extraordinary backdrop—and that’s zero rates and $120 billion a monthly QE for starters. Our risk management discipline dictates that I err on the side of caution when it comes to short portfolio composition. And I am nothing if not disciplined when it comes to managing risk.
So I’ve remained more focused on risk than opportunities. More specifically, I continue to want to avoid being caught short in higher volatility sectors in a backdrop of expected abrupt and unpredictable market rallies. We also prefer to be disciplined in avoiding being caught on the wrong side of erratic market rotations. And I’ll use the small-cap Russell 2000 to make my point here as an example. While underperforming the S&P 500 for the quarter, it was volatile and mustered a few notable rallies. From August 19th lows, the index surged almost 9% in only 10 sessions. And from the September 20th trading low, the Russell 2000 jumped 6.4% in only five sessions. In both of these rally periods, the small-caps significantly outperform the S&P 500. And as a disciplined manager of short exposure in a highly speculative market environment, that’s the reality.
It would be difficult not to impose risk control and reverse some short exposure into such price spikes. And this leads me to an important, though somewhat confusing, topic of rebalancing short exposure. Managing short exposure comes with different challenges than managing on the long side. That’s my first point here. Importantly, position sizes and account values move in opposite directions. Let me explain. Imagine you have a hundred thousand dollar account invested 100% on the long side. So your account is fully invested in a hundred thousand dollars of long positions. For this example, the market rises, and the long portfolio gains 10%, we’ll say.
Long positions rise to 110,000 as the account value also rises to 110,000, with the account remaining 100% invested. 110,000 divided by 110,000. Now let’s say the market drops 10%. Here long positions would decline to 90,000, while account value falls to 90,000. With the account again, remaining a hundred percent long. 90 divided by 90. Pretty straightforward.
The dynamic on the short side is different. Let’s imagine a hundred thousand dollars account, 100% positioned with a hundred thousand dollars of shorts. Say the market rises 10%, inflicting to 10% loss on the shorts or $10,000. Here account value drops to $90,000, which is simple enough. At the same time, short positions rise to $110,000. The original hundred thousand short grows an additional 10% as market prices rise 10%.
And this is where things get a little tricky. The percentage of the account that is short rises to 110 divided by 90—the 110,000 short position divided by the 90,000 account value—with account short exposure jumping to 122% of account value. How about when the market declines, creating profits on the short position? Say the market drops 10%, with short position value declining to 90 as stock prices fall, while account value rises to $110,000. The original hundred thousand plus a 10,000 gain on the short. Here account short exposure declines to 82%. 90 divided by 110. So as a discipline manager of short exposure, establishing a short position target is fundamental to the process, and adhering to this discipline requires that exposures be adjusted up or down to stay near target. This means incremental reductions in short exposure in a strong market environment to counter rising short exposure, and vice versa—incremental additions to exposure in a weak market. These types of trades where we are adjusting exposure are referred to as rebalancing.
And there are varying approaches, different risk management processes and philosophies to managing a short target and rebalancing. A manager can set a strict new miracle target or a target range. Rebalancing can be done daily or periodically at the manager’s discretion. For much of my 16 years managing a short mutual fund product, we generally rebalanced our target on a daily basis. Back when I was managing in a hedge fund structure, it was more of a target range and a discretionary approach to rebalancing. Much depended on the market environment. For Tactical Short, we’ve adopted somewhat of a hybrid approach. We established a specific short exposure target, but it’s more of a soft target where short exposure is allowed to move within a range. We rebalance weekly as necessary, though there remains a discretionary component.
With a public mutual fund, I always preferred a daily rebalancing approach. We would be managing daily fund flows anyway, so the general practice of adjusting short exposure to near target at the end of the trading day made sense. But especially in more volatile market environments, there remained a discretionary component to the process. For example, on a big down day in the market, we might not fully rebalance to target, knowing that a snapback rally the following session could force us to reverse this trade to rebalance back to target. For Tactical Short, with its separately managed accounts, we have strived to limit trading activity. A weekly rebalance approach was preferable, keeping short exposure in a range around us [rather than at an] established target.
If account holders follow trading in their accounts, they’ll notice more trades on Mondays. These are typically rebalance trades, and I understand if they can seem a little confounding. In a rising market environment, these will be small purchases that reduce short exposure back to target or at least toward target. In a declining market they will typically be small sell trades to boost exposure closer to target. And there can be rebalanced trades during other days of the week, either because short exposure has diverged from the target range or in response to market and fundamental developments. There are also circumstances where we can adjust targeted short exposure without actually executing trades. And this was the case recently, where short exposure— the target was increased marginally in response to fundamental developments, but additional shorting was not necessary because exposure was already half the new target level.
Let’s further expand this discussion, returning to that initial example of an account with a hundred percent short where a 10% market rise causes short exposure to jump to 122%. That’s that 110 divided by 90. First of all, keep in mind that the higher the short exposure, the larger the potential account gains and losses. And accordingly, the greater the rebalance challenge. I would prefer to avoid being forced into large rebalancing trades, buying high and selling low. That can over time chip away a performance. Throughout my career I’ve referred to it as the performance meat grinder.
Doug, often we’ll talk about beta. Maybe you could tie in beta and explore managing beta on the short side. And just as a reminder, beta is volatility beyond the S&P 500 index’s performance?
Sure, David. Yeah. Good point. That will add a little complexity here to our discussion, but yeah. Let’s talk some beta. Volatility beyond the S&P 500 index. And this is a critical issue on the short side. The example I provided above assumes short exposure has a so-called beta of one. That means if the market rises 1%, short positions will also rise 1%, inflicting a 1% loss to account value. But what happens when short exposure has greater volatility than the S&P 500? When it has a higher beta? And importantly, what about during a short squeeze environment when various short exposures become high beta and also highly correlated? It’s common during an intense short squeeze for the beta of a portfolio of popular stocks to jump to two, or even to three, meaning that if the S&P 500 rises 1%, the loss on the short exposure would be 2% to 3%. Not only are such losses quite painful, it creates a difficult rebalancing challenge. And no manager likes buying back their shorts into squeeze-induced price spikes.
But to ignore these spikes would mean that short exposure is allowed to rise rapidly, raising the risk of only greater percentage losses. These dynamics are fundamental to our process of managing short exposure in a high-risk environment. Keenly focused on portfolio beta, we adhere to disciplined risk management. We prefer lower beta to high beta, especially when financial conditions are loose and the market backdrop’s speculative. From my experience, shorting is a risky proposition in speculative markets. And that’s why we’ve maintained a very disciplined process to avoid shorting individual company stocks. And let’s add to the discussion the challenges of managing short exposure during a market topping process. Of course, everyone would love to short the market at the top, but market topping processes are typically periods of heightened volatility and uncertainty. While stretched valuations and deteriorating fundamentals create compelling short opportunities, increasingly wild volatility and its capricious sector rotations pose major risk management challenges.
In a recent weekly client update, I wrote that, “The stock market can be like a bull impaled by a matador’s sword. The mighty bull will succumb, but until that point, one must be prepared for absolute bloody havoc.” The topping process tends to become a cutthroat fight between the bulls armed with ample resources against the lowly bears with deteriorating fundamentals on their side. And especially when the bears begin to make strides, the bulls will really come after them when given the opportunity. Rallies and short squeezes can be ferocious. And it often becomes a situation of a game of chicken. As a manager of short exposure, I’ve got to ensure that if I lose a game of chicken that losses are manageable.
And to be frank, there were some folks that saw catastrophic losses. If you watched the meme stocks this last year—thinking of AMC and GameStop—and some of those were a 300% move in a day, 600% move in a week, 1000% move in a short period of time. The melt-up— it was not only buying, but short covering. And again, talk about beta management, I love what you said earlier, Doug. Preferring low beta to high beta when financial conditions are loose and the market backdrop is speculative.
That’s right, David. That’s fundamental to how we look at this. And we’ve been erring on the side of cautious risk management—and it seems for obvious reasons when stocks can go up a thousand percent in not much time. So we haven’t been attempting to pick underperforming stocks or sectors. We have remained in our default S& P 500 short, fixated on beta management in ongoing highly volatile and uncertain market and macro environments.
Enough of that. So let’s segue to the macro, where it was an absolutely fascinating quarter for top-down analysis. Key aspects of our macro thesis have begun to materialize. In particular, cracks have developed in China’s historic bubble. It’s also clear that inflation has become a major threat. Rather than transitory, inflation dynamics are appearing chronic. Global central bankers and bond markets have begun taking notice, posing great risk to an over-levered and destabilized world.
Let’s talk China. Recall that it took about 15 months in the US from the initial 2007 subprime eruption to the late 2008 systemic crisis. Crisis dynamics typically unfold over time. It’s a process. Ebbs and flows with regard to policy measures, market perceptions, and confidence with greed and fear. At this point, Chinese authorities are channeling Bernanke’s response to the subprime implosion, proclaiming that fallout from Evergrande is “controllable.” The problem is, Evergrande, with its $300 billion of liabilities, is but the tip of the iceberg. Estimates have total Chinese developer debt in excess of a mind-boggling $5 trillion, and there are likely hundreds of billions of additional off-balance-sheet obligations.
Virtually all data associated with China’s real estate bubble are, as they say, off the charts. According to estimates from Capital Economics, there are today up to 130 million unoccupied Chinese apartment units. That’s 30 million unsold and 100 million purchased, but not occupied. This is one of history’s spectacular speculative bubbles that Beijing’s repeated feeble tightening attempts completely failed to cool. Estimates have China’s property sector representing almost 30% of Chinese GDP, while 41% of Chinese banking-system assets are said to be associated with the property sector. Almost 80% of urban Chinese wealth is in apartments.
Well, existing apartment sales dropped sharply in September and were down 63% year over year during the first half of October. This suggests an abrupt and striking deterioration in market confidence. I don’t think we can overstate the ramifications from the bursting of China’s apartment bubble. And from my few decades of analyzing bubbles, things tend to be much worse than even bearish analysts like myself appreciate. I vividly remember the common refrain, “Washington will never allow a housing bust.” There remains today faith that Beijing has everything under control. Many believe recent developer woes are simply the result of tightening, Beijing policy tightening measures, and now they will back off and things will stabilize.
Let me suggest an alternative perspective. China’s vulnerable apartment bubble, pushed to only greater precarious extremes by pandemic stimulus measures, was poised to burst. Beijing’s tightening policies were simply the catalyst, and at this point, there’s no turning back. With Evergrande teetering on default, the five-trillion developer sector in disarray, bond investors chastened, and confidence shaken, I doubt the bubble can be resuscitated, even if that were Beijing’s goal, which it is not. Beijing would prefer to gently deflate some bubble excess, and that would be nice, but it’s just not the nature of prolonged, deeply systemic, runaway bubbles. Control them early, or later containment efforts will lead to a lot of financial and economic pain. Let them run uncontrolled for years, and you face catastrophe.
I am confident in the bursting-bubble thesis, though there is today an unusual degree of uncertainty in the analysis. Beijing has enormous resources available to deploy: their whole massive international reserves, and they run big trade surpluses. For now, they maintain tight control over the currency, and the Communist Party will withhold information from its citizens. It can obfuscate and manipulate. They will initially ring-fence their banking system while dictating targeted lending.
It is unclear how long it will take apartment prices to adjust to new realities. Local governments, they’re already pressuring developers against major price cuts. But I’m skeptical Beijing can sustain ridiculously overvalued apartments, often of suspect quality, and it will be impossible over time to suppress news of sinking prices. Word will travel quickly for subject matter of such keen national interest. How homeowners of depreciating apartments react is a huge unknown. Will millions of units hit the market with panicked sellers willing to accept steep discounts? Will owners of unoccupied apartments mail keys to the banks, just stop making payments? Will a banking system just sit on tens of millions of units? For how long can Beijing quash the market adjustment process?
And there is another critical aspect of the analysis that remains opaque. How much speculative leverage has accumulated in China’s Wild West credit system? With Chinese credit having offered such enticing yields in a near-zero-yield world, and with Beijing controlling a currency regime essentially pegged to the US dollar, surely enormous levered hot money has been drawn to China. But when it comes to leveraged speculation, there’s no transparency. I am confident that the global hedge-fund community has gravitated to Chinese fixed-income assets, while there’s been a proliferation of new hedge funds throughout China and Asia. China’s offshore bond market provided a convenient mechanism for leveraged speculation, and it’s no surprise this market has been the first to crumble under incipient bubble stress.
Doug, does your model of migration from periphery to core fit here?
It does, David. Good point. Absolutely. Absolutely.
So let’s talk contagion, and contagion occurs from the periphery to the core. So in this analytical framework, these crisis dynamics first unfold at the periphery, over time gravitate towards the core. And it’s the weakest players at the fringe that get in trouble first: those with highly levered balance sheets, liquidity constraints, vulnerability to any tightening of financial conditions. Stated simply, if the weak lose access to new borrowings, they’re toast. It’s worth adding that it’s the periphery that has been attracting massive yield-chasing speculative flows over the past 18 months, 18 months in particular, I guess, but even today, are acutely vulnerable to a shift to de-risking, de-leveraging market dynamics.
For purposes of analyzing China’s bubble, Evergrande and the highly levered developer community is at the periphery, while China’s state-directed banking system would comprise the core. Acute stress has unfolded at China’s periphery, stoked by de-risking, de-leveraging, and resulting dramatic tightening of credit availability and financial conditions more generally. And this development— it’s quickly reverberated both within China and globally. Risk aversion now has market players watching for the next shoe to drop. That’s the way this works. And deteriorating risk-versus-reward assessments into leveraging beget illiquidity and broadening risk aversion. We’ve seen contagion from China’s developer sector jump to Chinese high-yield borrowers more generally, as well as to Asian high-yield markets.
Moreover, there are signs that contagion effects are creating a major change in the financial backdrop for the emerging markets. Indicators of individual country risk have jumped, in some cases significantly. From my analytical perspective, crisis dynamics at China’s periphery have begun afflicting the global periphery, a major progression with huge market and economic ramifications. For example, last week, Brazilian stocks, they were down as much as 10%, with Brazil’s currency sinking another 3.3%. Local currency Brazilian yields surged almost 80 basis points to a near five-year high: 12.4%.
The Turkish lira sank 3.6% last week, with local currency yields jumping 70 basis points to a five-year high of 19.4%. Brazil and Turkey face major political, financial, and economic challenges. These risks are not new, but suddenly markets are reacting with a much greater degree of concern and urgency. You have to ask: What changed? Well, Chinese contagion has ratcheted up general risk aversion. Global liquidity has begun to wane. And financial conditions, they’ve started tightening, which is now impacting the more vulnerable markets and economies. And de-leveraging within EM heavyweights Brazil and Turkey will further negatively impact liquidity for developing markets more generally.
Meanwhile, inflation has become a pressing issue around the globe, unsettling central bankers and bond markets alike. This comes with major policy and market ramifications. Chinese contagion has already manifested into weakening EM currency markets, compounding inflation risk in key EM economies. There is now heightened pressure on central banks, EM in particular, to raise rates to bolster sinking currencies and counter mounting inflationary pressures. The world is today confronting a unique confluence of synchronized, fragile bubbles and surging inflation. And importantly, the worsening inflationary backdrop is reducing central bank flexibility—their flexibility to use monetary stimulus in response to market instability. This is poised to become a key issue with major ramifications for vulnerable global markets.
For some time now, markets have assumed that central-bank liquidity would put a floor under market prices, while also ensuring rapid market recovery in the event of a bout of instability. But central banks pushed things much too far. Especially after the pandemic response, unprecedented monetary stimulus further inflated historic bubbles while stoking the most powerful inflationary dynamics in decades. This creates a critical dilemma. When bubbles falter, central bankers will confront dislocated markets, demanding trillions of additional liquidity in a backdrop of already powerful inflationary pressures. This will be a real nightmare for central bankers that supposedly have everything under control.
China producer prices are up almost 10% year over year. Chinese energy prices have spiked of late, with shortages causing plant shutdowns and inflationary bottlenecks. This creates quite a quandary for Beijing, and it will have the People’s Bank of China thinking twice before opening the monetary floodgates in response to their deflating apartment bubble. It also means China, faltering bubble and all, will be exporting higher inflation to the rest of the world. Meanwhile, markets are underestimating the impact of China’s faltering bubble. Just a little bit of data here: Aggregate financing—and that is China’s main metric of system credit—ballooned to $43 trillion from 2017’s $25 trillion. Over the past 17 months, it surged an incredible $7.6 trillion, and that’s in US dollars, in precarious terminal-phase excess. Throughout this cycle, China evolved into the marginal source of global credit and, I believe, a key source of global liquidity more generally.
Chinese money and credit growth have slowed over the past three months, and credit expansion will now be hampered by a sharp slowdown in real estate-related lending. And the harsh reality is that financial and economic systems distorted by such prolonged, massive monetary inflation react poorly to waning credit growth. Beijing will dictate lending and investment to non-real estate sectors. We can be sure of that. But this doesn’t alter the reality that China faces a destabilizing change in the flow of finance throughout its asset markets and economy.
So how does a faltering Chinese bubble impact US markets? First, let me state that rising markets are self-reinforcing. They create their own liquidity, speculative buying, leverage, and higher prices. I believe a risk-off dynamic is gaining momentum globally with deleveraging and resulting fading liquidity. It’s a bubble dynamic and very much globalized, with markets tightly interconnected by unparalleled hot-money flows, leveraged speculation, and [unclear] trade. But so long as US market prices are rising, risks remain latent. It’s not until markets reverse lower and selling gains momentum that fragile underpinnings will be revealed. But my indicators are pointing to a shifting backdrop.
In both my weekly client updates and Credit Bubble Bulletins, I routinely discuss credit default swap, or CDS, their prices. CDS prices are the cost of buying protection against a bond default. Think in terms of purchasing flood insurance. During a drought, writing flood insurance is essentially free money, and the longer the drought persists, the more speculators will be attracted to the flood-insurance marketplace bonanza. This speculative excess insures insurance prices disconnect from risk, the risk of future flood losses. Yet everything seems to work just great: cheap insurance for the risk-takers building dream homes along the river, and easy profits for the enterprising speculator community. That is, until the torrential rains hit. When risk-off gains momentum globally, speculators will turn much more cautious writing market insurance. Many will move aggressively to offload risk. The cost of market insurance will rise, and liquidity will wane.
This has started to materialize over recent weeks, first in China, then the emerging markets, Europe, and even somewhat here at home. Two weeks ago, US investment-grade, high-yield, and financial CDS jumped to eight-month highs, with some notable upside price gaps indicative of underlying liquidity issues. I fully realize that it’s easy today to dismiss the impact of China apartment builders on booming US markets. Our media is more focused on Tesla’s trillion-dollar market cap and record stock prices. It some time ago became a full-fledged mania. And manic markets, by their nature, disregard risk.
Can you think, Doug, of a period of time that would be similar, where factors that you see, like the CDS increase, the expansion of cost, the increase in cost to ensure against default, was present in the market like you saw a few weeks ago?
Sure. Yeah. I can think of a couple of cycles where there were some similarities. Every cycle is different, each with its individual nuance. But at the same time, there are current speculative dynamics, and today’s backdrop is, for me at least, is definitely reminiscent of the summer of 1998. At that year’s July 20th highs, the S&P 500 enjoyed a year-to-date return of 23%. Financial stocks were even stronger, with the broker-dealer index up 31%. At the time, I was in disbelief. I was convinced Russia was on the cusp of financial crisis, and how can markets disregard the risks associated with such a major development? The answer in the summer of ’98 was a rather simple mantra: The West will never allow Russia to collapse.
I knew the hedge funds had huge levered positions in Russia’s debt. I was also focused on a big increase in derivatives activity to hedge against declines in the ruble and Russian bonds. It was clear to me that Russia was in trouble, and if their markets faltered, there was a high probability of illiquidity, dislocation, and a financial collapse that would rock the leveraged speculating community in global markets. And in the six weeks between July 20th highs and September 1st lows back in 1998, the S&P 500 sank 21%. Between July highs and October lows, the Broker/Dealer Index collapsed 56%. I was familiar with Long-Term Capital Management going into the crisis, but I was as shocked as anyone to learn of their egregious leveraging and $1 trillion notional value-derivatives portfolio. It’s not an exaggeration to say the global financial system was pushed, at the time, to the brink. The Fed orchestrated a bailout. There was the so-called Committee to Save the World, Greenspan, Rubin, and Summers, and rate cuts that reversed crisis dynamics and unleashed the 1999 mania.
Today’s risks, though, so greatly dwarf 1998 that they’re hardly comparable. In key respects, China’s bubble is without precedent. Its global financial and economic impact today rivals, if not exceeds, that of the US. The amount of global leveraged speculation today makes ’98 excess seem trivial. And while I can only assume there are no global funds as recklessly positioned as LTCM was back then, but there are reasons to fear that scores of funds have pushed risk and leverage to extremes. A seasoned hedge fund operator ran Archegos with more than 10-to-1 leverage in concentrated stock holdings. We also witnessed in March, 2020, the chaos unleashed when de-risking, de-leveraging gained momentum.
There’s another big difference between now and 1998: open-ended QE and now unshakable confidence that central banks will do whatever it takes to sustain the boom. 1998’s “the West will never allow a Russia collapse,” it’s evolved to today’s “Beijing and global central bankers have everything under control.” And such market perceptions are fundamental to the type of egregious speculative leverage and excess that ensure future crises. And clearly, the world has never witnessed the scope of excess that has accumulated over the past decade, and especially over the last 19 months.
Zero rates and the perception of endless central-bank liquidity have been fundamental to risk-taking and the accumulation of speculative leverage on an unprecedented global scale. But as I discussed earlier, surging inflation is in the process of limiting central-bank flexibility while creating an acute risk of a global spike in bond yields with panic de-risking and de-leveraging. 10-year Treasurys are trading, as we speak, with a yield of 1.56%. CPI is up 5.4% year over year. The last time CPI was up this much, 10-year yields were above 8%. Market expectations for inflation over the next five years, the five-year Treasury break-even rate, yesterday was at 2.99%, the high in data back to 2001 when yields were above 5%. Treasury yields were above 4% the last time University of Michigan one-year consumer inflation expectations matched today’s 4.8%. Why have bond markets remained so placid in the face of rapidly escalating inflation risk? Because of vulnerable global bubbles and the near certainty of additional massive QE bond purchases.
I’ll wrap up this section with a final thought. Markets, they’re fundamentally broken. Regrettably, at this point, there’s no fix, and our predicament is only worsened by additional monetary stimulus. Fixated on QE, bond markets disregard risk while yields fail to adjust, fueling manic excess throughout the securities, derivatives, and asset markets. There are always costs associated with market dysfunction. These costs are today great and rising exponentially. In particular, the confluence of low yields and liquidity excess today accommodates what are powerful inflation dynamics, ensuring that inflationary pressures become only more problematic and deeply ingrained. Importantly, fragile global bubbles demand uninterrupted ultra-loose financial conditions, the perfect environment for stoking a secular upswing in inflation. And this sets the stage for violent market reactions as central bankers realize they must move with resolve to raise rates and tighten financial conditions. David, back to you.
Thank you, Doug. We move to our favorite segment. Thank you for the questions that have been put in front of us. And Doug, I’ll start with one that does relate to the debt markets and sovereign debt in particular. There’s a point where the quantity of sovereign debt will force rates higher, which may increase the debt further. How will sovereign debt get resolved?
Yes. That’s such an important question, such an important issue. The world has never seen such debt growth and indebtedness, and it’s everywhere: the US, China, Europe, the emerging markets, and the developing economies. And the parabolic nature of global debt expansion during the pandemic, it’s frightening. Clearly, central bankers are hoping to resolve at least some of the debt with moderate inflation. And so far bond markets have been willing to play along, at least partly because of the expectation of additional QE, just ongoing central bank, sovereign debt purchases. At some point, I would expect bond-market focus to shift to a problematic scenario of rising inflation, and a more cautious approach with QE. This would usher in significantly higher global bond yields, and that could lead to a pivotal point for markets and central banks.
What happens if central banks then boost QE to try to push yields lower, but bond markets respond with only greater angst that more central bank liquidity risks further stoking inflation. And I worry about the next market and economic downturn. How much additional debt will be thrown at weak bond markets, fearing unending supply and surging inflation? I assume, and I guess at this point maybe I’m silly for this, but I assume that at some point markets will discipline profligate sovereign borrowers and reckless central bankers. I believe history is going to look back at this period, with its reckless money printing and these blank checkbooks for governments and MMT and such, as a crazy aberration. I fear a combination of inflation and debt defaults is in the world’s future, and I appreciate that question. Thank you.
Next question. Actually, two, I think I’ll work these together. Is it wise to have physical gold or silver at home? And the second question that I think is a good match, how do I divest of metal holdings when it becomes necessary?
First, owning metals addresses a variety of risks and the format you own it in, whether it’s in your possession or at an exchange, or as an ETF, each of those decisions, each of those formats has trade offs. Physical metals at home or in a safety deposit box gives you a tangible asset which is outside the financial system, which is immediately available to you. And you kind of think of that as a superior form of liquidity to fiat currency, and you gain the benefits of it being private and portable and without counterparty risk. The trade off of metals in hand, the liquidation is a bit of a process, and of course you increase a direct security risk.
So our sister company, a metals brokerage business buys and sells similar quantities. So, liquidity, regardless of the process involved, is not an issue. It’s not complex, but you could describe it as a bit of a hassle. So packaging and shipping, that all has to be borne in mind, but divesting is nonetheless just no big deal. Just don’t assume that it’s instant. So we come back to this issue of format. As you change the format, say to something like an ETF, and now you have instant liquidity. There’s no going to the post office to send a package. It’s just the click of the mouse, but what you exchange, the trade off, if you will, you pick up counterparty risk, you lose privacy, you lose the portability aspects which you have with the first example.
But what you gain is instant liquidity. We launched, with the Royal Canadian Mint a few years back, a program called Vaulted. We just launched the app for that in the App Store this last week. And it gives you the benefits of allocated tangible deliverable metal, but without the counterparty exposure. So ETF, liquidity without the hang-ups and detractions. You have better trade settlement actually than an ETF, but it gives you direct exposure. You can manage that from your smartphone or computer. Looking at both of these questions, again, is it wise to have physical metals at home? How do I divest of the metals? You’re really talking about what format you own it in, and again, just wrestling with what you gain and what you give up.
Again, you’re just weighing one against the other. With the Royal Canadian Mint program that I was talking about, divesting in that scenario is easy. You haven’t given up some of the natural security of gold. It is deliverable, unlike the ETF, but, like the ETF, privacy is out. You have to consider what the tradeoffs are. What’s important to you. And to that second question, how do I divest of metals holdings? It’s either more or difficult or less difficult. It’s more complicated or simple, depending on how you manage those tradeoffs.
Doug, the next question is for you, I think. When do you think the broad US stock market will top out? I think this is the— I don’t know how many trillion dollar question.
Are you sure that’s not for you, David?
Well, I do have a crystal ball.
Excellent. I need to borrow it.
I’ve been at this long enough to know. I should avoid guessing the timing when the market will top out. As they say, and I repeat this to myself often, the market is going to do what the market’s going to do. I’m surprised the bull market has lasted this long and has risen to such heights. But I do believe, I’ve spoken and written a lot on this subject, that the securities market is currently in a topping process. I hold a view that we’re in the very late stage of a multi-decade bull market. This is not your garden-variety bull market here. So from that perspective, we should not be surprised by an unusually prolonged and challenging topping process.
I wouldn’t be surprised at all if right now it turns out to be about the top of the market. But I’ve thought that before, multiple times. From my perspective, everything is pointing towards a major inflection point, inflation, monetary policy, bond yield, speculative excess, global markets, the economic backdrop, and certainly China’s faltering bubble. To me it’s all lined up here.
So I believe the probability that a major market top will be put in soon, over the coming weeks or next few months, is reasonably high. Let me also add that we use the services of an outside market technical analyst, one I’ve worked with now for more than 25 years. He joins our Wednesday team meetings, and walks us through his charts and analysis of market technicals. And that’s both for stocks as well as for precious metals. He believes the market is in the process of putting in a major secular top. He’s also unsure of the exact timing, but he thinks we’re getting close. So, thank you for your question.
And to that, Doug, just to add some color to those Wednesday conversations, the technical analyst has the advantage in conversation of saying on the one hand and then on the other. And so he’ll give us kind of the probabilities of a move higher or a move lower. And it’s pretty helpful to have both of those factored in. He would say, “Essentially, we’re on a knife edge through the first week of November.” And we are in the weakest month of the year, not evidenced by new highs being put in in the equity indexes at present. Nevertheless, this is a period of time where classically and seasonally, you could expect weakness. Once you get past the first week of November, you’ve got a little upside attributable to the Santa Claus rally and a few year-end rebalancing issues which could give you legs through the first month or two of the year.
So again, on the one hand is we could begin that decline today. But on the other hand, if they’re able to goose this through the first week of November, they’ve probably bought themselves a few months. He hasn’t changed his view that we’re in that long-term topping process. It’s just where the cracks begin to spread, widen, and concerns migrate from just a few to more than a few. Next question for you, Doug, is dealing with corporate and municipal bond holdings. Simply put, is it time to reduce corporate and muni bond holdings?
Sure. Starting with a general comment, I find the risk/reward calculus for fixed income securities these days is exceptionally unappealing. I personally don’t own them, wouldn’t own them in this environment. Inflation is a real and growing threat, with most securities trading with negative real yields.
As I mentioned earlier, bond prices are overdue for an adjustment to account for this secular shift in inflation dynamics. Meanwhile, enormous fiscal deficits ensure massive new supplies of Treasurys as far as the eye can see, yet money continues to just pour into bond ETFs, especially the corporate ETFs that provide a little bit of yield, and it’s for an obvious reason. The Fed is printing lots of money and cash is yielding close to nothing. So if my analysis is in the ballpark, then it would seem a good juncture to pare corporate and muni bond holdings.
All one has to do is go back to March 2020, which wasn’t that long ago, and see how the fixed-income ETF universe traded to get some sense for the losses that could again materialize in the event of a major de-risking, deleveraging episode. Many popular corporate bond ETFs sank a quick 20%. They rallied back, but that was that cycle. Today both corporate bonds and munis, they’re priced for perfection versus a risk backdrop that’s pretty close to the opposite of perfect. So thank you for your question.
I can’t help but add, in the ’70s as inflation started to pick up, being a fixed income investor had its problems. If you wanted to sell, you weren’t always guaranteed to find a buyer. And in many instances, you found brokerage firms sort of stacking up bond certificates and literally warehousing them in the mail room, waiting for further instruction to see if there was some sort of a market maker or bid that would be put to a price.
It’s been a long time since you’ve seen those kinds of market dynamics, but inflation does interesting things to the bond market. And it’s not something that we’ve had to deal with for a while.
The next question is on China, and this is interesting. What role or how large of a role does the Chinese government play in stymieing default within the Chinese economy and ultimately the global economy at large?
A great question. China’s Communist Party maintains extraordinary control over the financial system and economy, and clearly they’re now imposing even greater control. I suspect, however, that they have today significantly less control than what they’re given credit for. As for the economy and financial system, it turned more market-oriented during this cycle, significantly more so. Perceptions, speculative dynamics, and confidence became major factors in system development. Market-based credit became a substantial component of overall credit expansion and inflating asset prices. Apartments in particular fueled major structural shifts in Chinese finance and economic development. As I discussed at length earlier, it all evolved into historic credit asset and economic bubbles. Beijing is today clearly uncomfortable with myriad risks, and on many fronts is moving aggressively to regain control.
More specific to your question, the Chinese government can clearly play a major role in stymieing defaults in China. They’ll orchestrate bailouts. We saw that recently with China Huarong. They can add liquidity, cut bank reserve requirements. They can direct their major banks to lend to specific troubled borrowers or troubled sectors. But can they maintain confidence—confidence in the bond market, in apartment markets, in equities, in derivatives?
More specifically, can they sustain extreme inflating apartment prices? I have my doubts, I’ve said as much. And sinking apartment prices will make it challenging for Beijing to maintain confidence in Chinese finance and Chinese economy more generally. Can they control consumer confidence in the unfolding environment? Big question. And a real estate collapse will leave the Chinese banking system deeply impaired. Sure, they’ll move to recapitalize their banks, but that will come with a very steep price tag. And at some point I would expect a crisis of confidence in China’s financial system currency, and that would put Beijing in a very difficult situation.
As I mentioned earlier, Chinese policymakers already face the dilemma of surging inflation, these energy shortages, bottlenecks. These are problems all made worse, not better, all made worse by more liquidity and credit expansion. So expanding on your question a little bit here, I believe the illusion of Beijing’s tight control over everything has begun to slip away a bit. And there will be one major adjustment coming in China and globally if perceptions end up shifting from, Beijing has everything under control to, oh my gosh things in China are out of control. And as far as what this means, ultimately, for the economy in China and globally, I expect China’s focus to be increasingly dominated by domestic considerations as their bubbles deflate. China’s economy was critical to bailing out the global economy after the collapse of the US mortgage finance bubble. But now, as the epicenter of the unfolding global crisis, I wouldn’t count on much help from Beijing going forward. Thank you for your question.
Doug, going back to your earlier comments, your former comments, obfuscate and manipulate were two words that you used in reference to the Communist Party withholding information from its citizens. And clearly to manage this economic environment and potentially manage impact into the global economy requires some of that obfuscation and manipulation. You see that played out in the management of news flow. You referenced in the Credit Bubble Bulletin last week the closure or the elimination of Caixin, a very reputable news outlet which gives a lot of information and details to what’s going on in the Chinese markets. You can no longer read them. So managing the flow of information is now a critical part of this obfuscation and manipulation. But to your last point, that domestic considerations are critical to the Chinese, inflation is something that does not lie.
And inflation is not something that you can hide under a bushel. It’s very difficult to convincingly manipulate a statistic when the people, and you’re talking hundreds of millions of people, cannot feed themselves. So inflation becomes sort of a great reveal as to what has been obfuscated, manipulated. And that idea that they can ultimately maintain control is one of the reasons why inflation is a very significant factor moving forward.
Great point, David. Great point.
The next question, what are your thoughts on transitory inflation? Do you believe Yellen’s statement that inflation will be tempered in the near future? I’ll give this a go.
There are aspects of the current inflation which are driven by supply chain concerns, and some of those will clear up. Some of them will in fact be transitory.
I think it’s gotten more complicated as time has gone by. And so the Fed’s original view and the Treasury’s original view that this would be very, very transitory, as Powell has already said, he’s disappointed at how long it’s taken because his original assumptions were that they would already be done by now—that is the inflationary pressures would be gone by now. What are not transitory, and I think this is really key, what are not transitory are the behavioral changes amongst consumers and the upshift in wages. So wages are being pushed 10, 15, 20, 30% higher amongst professional white collar workers, and anywhere from 10 to 25% higher amongst blue collar workers. Now, I’m seeing this directly, and in talking to other business owners in Colorado in probably a five state area, again those numbers are anecdotal to people I know who are dealing with wage increases necessary to maintain their businesses.
And that, by the way, does not include an increase in benefits or signing bonuses or things of that nature. Wage pressures will ultimately maintain inflationary pressure on both goods and services. So the wage side of the equation impacts both an increase in goods and services inflation. The other aspect that’s worth keeping in mind is that underinvestment in the commodity sector over the past decade, if you look at decarbonization and the move towards certain environmental goals and objectives, that’s led to underinvestment in the commodity sector for over a decade, and that will keep pressure on inflationary pricing of commodities, which clearly has more of an impact on consumer prices and prices paid for goods. So you have actually multiple sources of pressure, both for goods and services on the one hand, and then exclusively on goods, if you’re looking at commodities.
I think when you look at Yellen, Yellen would prefer to think of the bond market she manages, we’re talking about the Treasury market, as a market that is returning to a low inflation environment. It certainly represents less headaches for her with less volatility in that market. She is still presuming control of that market. But I think she’s also old enough to remember a time when bond vigilantes brought discipline to the debt markets when no one else would, which is what you mentioned earlier, Doug, where the markets do come alive at a certain point and there are reasons why that has not happened to date. Anticipation of greater QE, and I think a lot of belief that, how could the Fed and treasury be wrong in their projections of inflation being transitory?, to the extent that the bond market is positioned on the belief that the PhDs simply can’t be wrong. Maybe inflation is the necessary catalyst to revive the listless bond vigilante. Tempered inflation, I think that’s probably more of Yellen’s morning prayer than it is her prophecy or prognostication.
The next question is on China, and it’s, “Is China turning inwards in anticipation of the next global financial collapse? Widespread real estate Evergrande problem, massive accumulation of gold, closing the crypto market, ratcheting down on tech media, and Jack Ma being forced to get his mind right are all serious and notable examples of a looming crisis.”
I don’t disagree with that. What I would say is I don’t think the purpose of ratcheting down controls is safeguarding in battening down the hatches to manage market disruption, as much as it is a consolidation of power for Xi Xinping. He’s on the eve of taking an unprecedented third term in office. What he does over the next five years, assuming that he gets it, will have required that consolidation of power and the silencing of dissent. So first things first, there’s circumstances which are not in your control. And he certainly doesn’t know that on date X, Y, or Z, he’ll be facing a financial crisis, but he does know that he wants the power to be able to manage the next five years effectively.
Yes, managing a financial crisis may be in the cards, but even that is best navigated, from his perspective, with unlimited power, with limited freedom of speech, and limited exit strategies. So point taken in terms of closing of the cryptocurrency market, the state continuing to accumulate gold, I think it boils down to these two tools.
If you’re at the receiving end, then it probably feels more like weapons or sharpened blades, but inflation and financial repression are easier to orchestrate as policy choices when the audience is captive. So yes, the controls exist. Yes, once you move into the framework of financial market deterioration, if you’ve closed the gates, so to say, you can bring these tools to bear, inflation and financial repression is a choice.
I just would go back a little bit further and say, the Communist Party started re-inspiring its membership, reinvigorating their set of ideals six to seven years ago. And we were even then watching as friends of ours in China grew far more cautious in anything that they would put in print, in anything that they would say publicly. Even on phone calls, there was a marked change in discretion, going back multiple years. And again, that was because the power shift was in play even then. The power shift speaks to an intensification of politburo direction. And I think ultimately of redirection of the economy, redirection of capital, redirection away from the winners of the past 20 to 40 years and towards those that the state deems critical to the next stage of Chinese development. And Xi Xinping has an idea of where he wants that to go. He cannot get it done between now and the end of his term, thus the need for clampdowns and control, managing the media, et cetera, et cetera, so that he has the resources at his disposal to take China into the next great era, in his view.
David, I have just a brief thought here. For me, the perception of the great Beijing meritocracy could not be more divorced from reality. Chinese officials have incredibly mismanaged their financial system and economy, but they will never be willing to accept responsibility. One way or the other, I expect them to blame foreigners, the US and Japan in particular. And I have for a while feared this narrative of a bursting bubble increasing the odds of a confrontation over the Taiwan issue, and what seemed farfetched not long ago is becoming an all-too-real threat, unfortunately.
Well, that plays off of kind of a domino effect, if you will, where you can have a crisis that emerges in one sphere, for instance the financial markets, which begins to have a real impact in the economics sphere, a different but related sphere. And, out of that economic crisis comes the need for policy measures, where politicians are scrambling, and that form of a political crisis— It can, as, you were alluding to, lead to a blame game if you’re not going to take responsibility for the chaos which has emerged either within the financial markets or within the economy, and you may even be fighting against other powers within a domestic political regime. Not everybody at the politburo is on the best of terms of Xi Jinping.
Then, to redirect animus and energy, the blame game. So you’re right. The U.S, Japan, the Taiwanese strait, all of these things are actually almost like a T-ball setting on the T. When needed, you can swing hard and refocus Chinese energy towards something more national in nature. So, we may find ourselves migrating from a one-dimensional financial crisis, with all the complexity that that entails, into a full-scale international political imbroglio, I guess, is the word they like to use.
Next question, “What do you suspect the short or long-term effects of the supply chain disaster to be?” So we’ve got a record queue of container ships. What is the supply chain disaster? How is that going to affect stocks, commodities and the dollar? I’ll say something, And if you want to comment on it, too, Doug, feel free.
I think reassessment of Just-in-Time inventory management is kind of an obvious first step. Everybody looks at the way they’ve done business and says, wow, we’ve got these dependencies and we’re going to have to reassess the value of cheap labor someplace else set against the insecurity of managing a business through not having a product to sell and the cost savings which we had on the labor side, which has gotten eaten up by rising freight. So, if you look at the frailties of the Just-in-Time inventory management system, which has been in place now for 20-plus years, coupled with the rising cost of freight. I think that suggests an onshoring, process, an acceleration of onshoring as not just a short-term fix, but even a longer-term trend.
And, where that becomes very interesting is I think that goes a long way towards supporting a longer-term inflationary trend, where you could have your freight costs then return to lower levels. But if we’ve brought home domestic production, then you’re talking about the cost of goods moving to a new permanent and higher level. We’re frankly not seeing the trade deficit reflect much of a move towards onshoring at this point. So that’s a hypothetical, but I think a real possibility as boardrooms try to figure out how to manage their risk.
The impact on commodities, that trend is already towards higher prices. And, Jeff Curry, who heads the Goldman Sachs commodities research department, pointed out recently that underinvestment in the old economy has delivered what he describes as the revenge of the old economy. Higher prices are going to persist as a result of that underinvestment, and that’s not going away anytime soon. So the supply chain disaster has just brought to the fore, in the fronts of our minds, some pricing realities that we have now, and maybe facing for some time to come.
Yeah, no doubt margins are at risk. So, coming back to stocks and the question about, what’s the impact to stocks? If margins are at risk, if you look at sort of the causal chain, margin squeeze, then you could assume earnings compression, stock price decline. These seem reasonable for many companies, not all companies, but for many companies to encounter.
I’ll just briefly reiterate your comments, that higher inflation is becoming ingrained. Inflationary psychology is taking hold here, changing perceptions, attitudes, and behavior. So, there’ll be more stockpiling, more hoarding, and that’s by individuals, businesses, and governments at home and abroad, and labor has greater bargaining power today than it’s had in decades. It’s all poised to— a secular shift and inflation dynamics, which, as you just stated, we believe is constructive for commodities. So far, your global bond markets have not responded to a secular upswing in inflation. When they do, I expect the general risk markets to suffer. And that’s certainly equities, corporate credit. Lots of speculative bubbles will pop. Many stocks and sectors will suffer significantly. There will be opportunities on the long and short side as well. As for the dollar, at the end of the day, I believe surging inflation is negative for this financial centric U.S Economic structure.
It depends a lot on policymaking, but I expect an inevitable crisis of confidence in the dollar. In the meantime, near-term prospects will be heavily—that’s dollar prospects—will be heavily influenced by faltering global bubbles and speculative dynamics.
So this is also in China. “Will China’s aggressive behaviors have any effect on stocks, commodities, and the dollar?”
I believe aggressive behavior out of Beijing, it’s going to have profound effect on just about everything, including stocks, commodities, and currencies. Their aggressive behavior could run the gamut from liquidity injections, credit expansion, bailouts, to geopolitical actions. The People’s Bank of China, they’ve been aggressively adding liquidity the last few weeks, and I’ll assume they’ll continue to be only more aggressive as their crisis unfolds. This should be one more added source of support for commodity markets. But if a disorderly collapse in China’s apartment bubble leads to credit contraction and global risk off, there would be a bear case for the more industrial commodities that are in such strong global demand currently. That’s something we’re going to have to follow closely. When I think of aggressive Chinese behavior, as I just mentioned, I do fear how they might lash out when their bubble collapse turns serious.
It doesn’t take a wild imagination to envision Beijing using Taiwan reunification as a rallying cry for nationalism to distract a Chinese population that’s been blindsided by financial economic hardship. This is, I believe, a growing risk for global markets and economies. The question also mentioned the dollar. I would say the dollar and renminbi are wildcards. I believe the renminbi is vulnerable to collapse in Chinese bubbles, which has a potential to spur dollar safe haven demand. At the same time, the U.S dollar is at great risk from unending trade deficits, current account deficits, monetary inflation, massive fiscal deficits, and its own risk of deflating bubbles. We will, of course, we’ll be closely monitoring actions from both Beijing and Washington. Excellent question.
The next question is, “Vaccine mandates appear to be affecting human resources in all business sectors. If legal actions aren’t successful in reversing the trend to eliminate the unvaccinated, what effect will that have on the economy and associated financial products?”
What comes to mind is, you’ve got issues which your policy induced. Think of it in those terms. Wage pressure is, to some degree or partially policy induced, to the degree that inflation remains endemic, like COVID remains endemic, you’ve got economic pressures, which are going to increase for businesses and households. So, consider in turn the impact of rising rates as a natural consequence of inflationary pressures, and the toll that exacts on all financial products. This issue of people working, not working, creating pressure for vaccine mandates, hits the labor market at the margins.
I think the number is around 4.3 million that are out of the labor pool versus pre-pandemic numbers. The widespread pressures are there. We have employers in virtually every category of work. We’re saying they’re having a hard time finding people to work. So, it hasn’t taken very large numbers for there to be this pressure on wages. People just don’t want to come back to work. There is more pressure there, created by marginal shift, than you might’ve imagined. Why are people not returning to previously held jobs? I can’t say. There’s many different interpretations, including the increasing cost of childcare and a whole host of other things. But I’m returning to inflation here because I think that’s where financial products are incredibly vulnerable. Owners of assets have put faith in Yellen and Powell and the conclusion that inflation is transitory, and the normal is just around the corner. The market to me is not well positioned for being wrong on that.
The next question, reads, “Internationally there’s a push to digital currency. Everything, all transactions and money, will be a blip in a computer. Any sense of timing on when this will be the only acceptable method of transacting business? Also, your opinion as to whether subsequent transactions using precious metals such as silver coins or whatever, rather than paper dollars would be an illegal act.” So there’s kind of two points there on precious metals, and then kind of also the move towards crypto.
Timing, I think we should have our own central bank digital currency by the end of next year, by the end of 2022, the Federal Reserve and the Treasury have already done a lot of thinking on it. There’s no doubt that the private sector push into cryptocurrencies and the popularity of Bitcoin and Ethereum and others, I think that is going to be circumvented by official government offerings which allow for the advantage of having that.
And I think the reason why you see them throw their hat into the ring, ultimately they’ll dominate the ring, is because if the direction is towards digital, then the only way that they can continue to implement modern day monetary policy is to control the money. So, Bitcoin and Ethereum have popularized the idea. They brought digital currencies into the mainstream, not because of an innovative value add, this is, again my opinion, but really because the price has gone up wildly consistent with everything else, the everything bubble, if you want to call it that. With that bubble, frankly, if you look at the trajectory of some of those things, they’re the largest bubbles we’ve had in the history of the world.
But again, I don’t think that moves us towards a wild, wild west of currency trading and transactional usage with the cryptocurrencies that everyone has in their minds—what’s captured the speculative energy of the day. Quite the opposite, quite the opposite. I think we’re moving towards a centralized digital system that tracks, and maybe even control transactions, again, according to preferred policy outcomes and targeted audiences.
It’s not that the People’s bank of China were against digital currencies, they were just against the digital currencies that they didn’t control. Because if you have the ability to migrate into or opt out of the system, it just makes it that much harder to implement the policies that might, that might bring order to chaos. So, frankly, and I know this may sound, this is very, just a personal thought here, but I can’t think of anything more dystopian and anti-free market than the launch of the central bank digital currencies.
When you think about Keynes— the popularity of Keynesian economics today, Keynes wanted to eliminate the rentier class. Of course, he was the exception to that rule. The rules apply, but they didn’t apply to him. But I think the cryptocurrencies distributed by central banks provide a very viable means to that end of eliminating the rentier class. And in saying that, I realize I skipped past the private sector iterations because for all the talk of use cases with existing digital currencies, actual implementation is scarce. They remain hypothetically viable. But in my view are subject to overwhelming regulatory pressure. And I think that the day that transactions within the crypto, private crypto market, when they allow for circumventing our centrally directed money system, that’s when you’re talking about, again, control. Ken Rogoff said it best regarding cryptocurrencies: What the private sector innovates, the public sector regulates and then appropriates.
That was actually an article, a quote from an article he wrote for Foreign Affairs magazine maybe two years ago. The second point of the question was on metals, and making gold and silver illegal would be one way of closing off a viable exit for the financial system. That’s clear, if people are seeking an exit. I would say that, to date, the sector does not attract enough attention to be concerned with. So at some point it may have a sufficiently high enough profile to matter. But today you’d see more scrutiny and pressure coming back to this issue of illegality as applied to the cryptocurrencies than you would gold.
I have a reading assignment for all of you. And, when Alan Greenspan wrote his essay titled “Gold and Economic Freedom,” he pointed to one of the most essential elements of gold ownership. And, what he was underscoring was the importance of agency and action, and the fact that agency and action are enabled by resources that others cannot control, which, as he points out in his essay, going back to 1966, drives the statist mad, drives the statist mad.
So it’s not just economic freedom and the foundational role that gold has played through thousands of years. Again, promoting agency and free choice within a commercial context, it’s also the freedom of the individual which it helps maintain. And I can go anywhere in the world and spend gold. I can convert it into any currency and thereby pay for anything that I need using that as a tool. So, just hypothetically during the next financial crisis, policymakers will attempt to stabilize our system of finance. And it’s likely with draconian measures, whether it’s Chinese draconian measures, or even here in the U.S, draconian measures. We’re talking about choosing winners and losers as a way of managing downside and trying to engineer recovery. Sacrifice of the few for the benefit of the many.
And maybe I’m getting too philosophical here. But I think the question asked points, it points to the elimination of a critical choice, which in and of itself is an indicator. It’s a signal. It’s an indication. If you go back to Greenspan and his more deal idealistic days, what that would be an indication of if you wanted to make the trade of gold or the ownership of silver coins, things like that, illegal, you’re tipping your hat, you’re tipping your hat.
So, reading assignment for tonight, I knew you were looking for something to do this evening. If you’ve never read the essay, that that is your assignment, “Goal and Economic Freedom,” Alan Greenspan, 1966. I think the move against the metals is unlikely in the U.S for two reasons, and I’ll end with this. Today the Fed controls the money supply. Gold is not real competition to their monopoly and is not a factor in their ad hoc approach to money supply management. It was during the gold standard period, going back to the 1930s, which is one of the reasons why it was eliminated. It’s not a challenge today. Secondly, limiting gold and silver ownership. Think about what this conveys, again, as a signal, as the largest debtor nation in the world, I think it sends the wrong message to your creditors. It’s an act of desperation and it signals the fear of collapse.
It is the equivalent of capital controls. When you see a country implement capital controls, you know something is significantly impaired. When implemented, everyone knows the game is up. So if we lost access to the international credit markets, you’re talking about unimaginable damage, irreparable damage to our financial system. Because given our current levels of deficit spending, you’re talking about the scenario that could potentially throw us into hyperinflation. That’s in fact what did it for Weimar Germany. Once they lost the international financing taps, when those taps were turned off, that’s when what they were doing had a massively inflationary effect. So, Doug, I have one last question for you. This is sort of a philosophical. Let’s see, wait a minute. I may have another here.
I did not see this one coming in on the line. Let me just read through it real quick. No, it’s just a comment. Thanks. Yeah. That’s just a comment, not a question. So, this one would be for you, they say, Doug, they say the days are long, but the years are short. I think that’s in reference to raising children. Maybe the job is never done. But when you get to the end of the financial cycle and see the topping process forming, what do you think? How do you process that? You get to be right? But what goes through your mind? Is it the end or are you just beginning at that point?
No, David, I think in just last Friday’s CBB, I made the comment that I’m really dreading chronicling the downside of the cycle. For me, it’s just, it’s going to be painful. And I know every week when I write, it’s going to be a reminder that this didn’t have to happen. So I’ve said this all along. I hope so much to be wrong on the analysis. Just disappear and be wrong. I’m going to Chronicle it through to the end, but vindication, none of that means anything to me. It means nothing. So, again, I just hope I’m wrong.
Yep. Well, thank you for the work that you’ve done in the Credit Bubble Bulletin. I know those who are listening probably are also routine readers. We’ll continue to keep in touch via that, and would just suggest that if your interest is more than slight, this is a good time to have a conversation with Doug. This is a good time to have a conversation with our team, about implementing tactical short as an overlay for your other strategies on the long side. So I’d love to visit with you. We’d love to have something in motion. This is an intriguing chapter in the history of finance, and we’d love to partner with you in any way that that brings about greater flourishing and prudence to your asset management.
Thank you for time today. And appreciate you joining us.
Thanks everyone. Good luck out there.
FREQUENTLY ASKED QUESTIONS:
What is the purpose of the Tactical Short Strategy?
The McAlvany Wealth Management (MWM) Tactical Short is designed to generate positive returns from downside volatility within the equities market. The strategy is not intended to necessarily hedge an equity portfolio dollar for dollar, but will instead strive to opportunistically capture gains as particular stocks and/or sectors decline in value. The objective of our short offering is to provide a mechanism for reducing a client’s overall investment portfolio risk profile while providing downside protection during periods of market instability.
The Tactical Short is described as non-correlated instead of consistently negatively correlated. Can you explain?
A constant negative correlation would imply always being positioned fully short, thereby reflecting the direct inverse returns of the asset mirrored. Such approaches are indifferent to risk. It is fundamental to our strategy to be selective and willing to wait for more favorable market conditions and compelling opportunities. Our focus on risk versus reward metrics dictates that there will be periods when we will be minimally short. Our decision-making process is driven by intensive analysis of a mosaic of indicators, from both “top down” and “bottom up” perspectives. Depending on our analysis of the backdrop, we will have the flexibility to position either opportunistically or defensively – to expand short exposures in favorable backdrops or significantly reduce exposure to mitigate losses during highly unfavorable environments for shorting. Positioning the strategy as “non-correlated” is consistent with the objective of avoiding the type of heavy losses suffered by negatively correlated funds during bullish periods.
Is this a fund with pooled assets, or will investors have separately managed accounts (SMA)?
We have chosen to structure the Tactical Short offering in separately managed accounts to allow for advantageous investor transparency, liquidity and, on occasion, some tailoring to better suit the needs of an institutional or individual investment mandate.
What kind of accounts can be opened?
While the Tactical Short offering was developed with the discerning institutional investor in mind, it may be appropriate for individual, trusts or corporate accounts.
Can I transfer a retirement account?
That’s not possible. The nature of shorting requires that securities be borrowed prior to consummating a short sale. Regulations mandate a margin account for such strategies, and margin accounts are prohibited for qualified plans (IRA’s and other retirement vehicles).
Is positioning a portfolio to benefit from declines and volatility the only investment style MWM offers?
Definitely not. While MWM specializes in alternative asset investment management, we do offer traditional portfolio management along with our natural resource and long/short strategies. Tactical Short is a unique offering intended to compliment other risk asset allocations held with MWM or elsewhere.
What do you see as an appropriate percentage allocation to something like the Tactical Short from an overall portfolio mix perspective?
An allocation to our non-correlated Tactical Short adds value by reducing overall investment portfolio downside risk. We would suggest exposure to the Tactical Short in the range of between 5 and 20% of risk assets to help reduce overall portfolio volatility, enhance liquidity and provide meaningful downside protection. For example: $2,000,000 in total equities and risk asset exposure would typically benefit from a $100,000 to $400,000 Tactical Short allocation. With an allocation above 20%, we would assume that an investor has chosen our product to place a directional bet on a declining market.
Are there Minimum account sizes?
Institutional investors would generally have a minimum account size of $1,000,000 while, where appropriate, qualified individual investors would be considered with minimum account sizes at inception as low as $100,000.
What are management fees for Tactical Short?
1.0% per year paid quarterly in advance (25 bps per quarter).
If I am utilizing margin in the Tactical Short, will my account be charged for margin borrowing expenses? Are there other expenses I should be aware of?
While the portfolio manager seeks to minimize such costs, there are typically expenses associated with borrowing securities. Borrowing costs are generally small, with the exception of hard-to-borrow securities. Traditionally, borrowing costs were offset by the return on an account’s cash collateral.
Why would I choose a MWM Tactical non-correlated account instead of a short ETF or options strategy?
We believe our strategy is superior to competing “bear” products and instruments. Being fully short all the time simply doesn’t work. Options strategies are risky and tough to execute successfully. In our eyes, risk management is paramount. The key to success on the short-side is having the flexibility to navigate through various market environments. To do so successfully demands a disciplined investment process coupled with a sound analytical framework. Importantly, there’s no substitute for experienced active-management on the short-side. In our view, our new offering incorporates the most seasoned portfolio manager with the most compelling analytical perspective, investment process and philosophy available in the marketplace.
Does MWM custody assets? If not, who is the custodian?
We do not custody assets. Our preference is to retain the services of a preeminent third-party custodian, an arrangement that facilitates online access to account holdings and myriad amenities common to a brokerage account. Tactical Short client assets are held at Interactive Brokers.
Can I send additional funds to my account in the future?
Sure. Additional funds can be added in any quantity. Because Tactical Short accounts can be rebalanced daily, there should be minimal delay in adjusting positions sizes to incorporate flows into (or out of) your account.
Will this offering be closed at some point to new money?
We do not at this time anticipate capacity issues that would cause us to close the Tactical Short to new investors or restrict inflows.
Do I need to reserve a place?
That’s not necessary. We would, however, highly recommend funding an account and then to allow us to determine the appropriate time to allocate assets. This is much preferred to beginning the process in the middle of unstable market conditions.
Are assets always invested on the short side?
No, there will likely be periods when we choose not to hold short exposure. Our analytical framework and proprietary indicators assist us in gauging both when conditions are more favorable for shorting along with the most attractive composition of short exposures (i.e. stocks, sectors, the market, etc.) from a risk versus reward perspective. When conditions are expected to be unfavorable, the Tactical Short is content to watch from the sidelines (sitting in cash and avoiding short exposures). Such a tactical pivot from being opportunistically short to defensively positioned creates the flexibility necessary to capture gains and then safeguard them from major market advances.
If Tactical Short operates with hedge fund-like versatility, why not charge the standard “2/20” (2% management fee and 20% of profits)?For one, we do not share the typical hedge fund mindset. By keeping fees to a minimum, we endeavor to develop long-term partner relationships with our investors as we together navigate through the vagaries of market cycles. We did not develop our new product with the intention of getting rich from the next market downturn or financial crisis. We were motivated by what we saw as a glaring lack of quality flexible short-side products – the type of strategy that savvy investors could live with comfortably during these uncertain and unsettling times.
When you are not short how are funds allocated?
It’s a little confusing. Unlike long investing, cash is not used up in the process of borrowing and selling securities short. Whether fully short or not short at all, account assets remain mostly in Treasuries and/or cash-equivalents. Some of the cash holdings are used as collateral against short positions, but this cash remains in the account. So even in periods of market stress, Tactical Short assets should remain safe and highly liquid.
How liquid are the funds in my account?
Funds are generally available same day. One of the benefits of a separately managed account is that requests for same-day liquidity can be accommodated. Short positions will also be highly liquid. In the event an account is liquidated, it will be possible to unwind (“cover”) short positions upon request and return cash collateral on a standard T+3 settlement basis. No “gates” here.
Can I add money to an account in the future?
Yes. There is a minimum to open an account but should you desire to increase your allocation to the tactical non-correlated theme you may do so at any time.
If future gains boost the size of my account, would you recommend allowing my short allocation to increase over time or instead employing a total portfolio re-balancing approach?
Having access to liquidity at market bottoms can be highly advantageous to value-conscious investors. We’re going into our new venture with the assumption that Tactical Short’s ability to create liquidity in down markets creates an enticing long term value proposition for astute investors. While tactical decision-making will be a primary management focus of our short offering, we fully expect our long-term investors to engage in cyclical allocation decisions consistent with their individual goals and circumstances. As partners, we’re committed to doing our very best in offering valuable insight as well as attractive investment alternatives to best serve our investors as they strive to generate and preserve wealth.
- Don’t be risk indifferent – unwise to maintain 100% short exposure all the time
- Don’t disregard the macro backdrop
- Don’t ignore the market
- Don’t disregard portfolio beta
- Don’t pretend long/short strategy mitigates risk
- Don’t only short stocks
- Don’t maintain concentrated short positions
- Don’t only short a market index
- Don’t have illiquid positions
- Don’t rely on potentially problematic third-party derivatives
- Don’t invest short collateral in potentially risky and illiquid instruments
- Don’t be a “one-trick pony” – (i.e. company research, index or quantitative focus)
- Daily intensive, disciplined risk-management focus
- Wisely adjust exposures based on market risk vs. reward backdrop
- Be flexible and opportunistic with individual short positions and overall exposure
- Incorporate experienced top-down macro research and analysis
- Search for opportunities rather than fight the market
- Intensive beta management:
- Protect against short squeezes and “upside beta” issues
- Guard against high market correlations
- Have as many tools in the toolbox as possible:
- Short stocks, sectors, indices, various asset-classes, global perspective,
- Liquid put options
Incorporate a technical analysis overlay with risk management focus
Protect against potential systemic risks:
- Avoid third-party derivatives
- Liquid put options
- Vigilant cash and liquidity management
Incorporate the best of micro, macro and technical analysis
For more information or to inquire about opening an account for the Tactical Short Strategy, please contact us: [email protected]