David:  This is our 2nd quarter 2019 Conference Call for Tactical Short.  I am David McAlvany.  With me today is Doug Noland.  What an exciting quarter to have been witness to.  We are seeing some amazing things in the markets which the context is frankly unprecedented in all of financial history.  

We titled the call today “What’s Behind the Global Yield Collapse?”  For perspective, we have roughly 25 trillion dollars in bonds which today in real terms have negative yields.  We have 13 trillion which have nominal yields which are negative.  We’ve spent some time with scholar and author Richard Sylla this week and the gist of the conversation – he wrote the book which relates 4000 years of history on interest rates and he just kind of sits baffled as a professional and as an academic from New York University – it hasn’t happened before.  

What are the possible implications?  In many respects, this is brand new territory in terms of financial experimentation, monetary management, etc.  So we’re going to explore some of the supply and demand dynamics and the things that are going into what is behind the global yield collapse and I think today will be very fruitful for you.  

I want to thank everyone for jumping on this afternoon’s call.  As always, our special greetings to our account-holders.  Building long-term client relationships is our motivation for working as hard as do.  

I will begin as usual with general information for those of you who are unfamiliar with Tactical Short.  More detailed information is available at mwealthm.com/tactical short.  The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio while providing downside protection in a global market backdrop with extraordinary uncertainty, and we believe, extreme risk.

The strategy is designed for separately managed accounts and in this format we think it is incredibly investor-friendly.  You have full transparency with a view of those accounts, flexibility, reasonable fees, no lock-ups, so again, prioritizing that investor-friendly nature.  We will short securities, stocks, ETFs.  We will also on occasion buy liquid listed put options. 

As you know, shorting entails unique risks.  We are set apart from others who attempt to do something similar, both by our analytical framework which is unique to us, and our uncompromising focus on identifying and managing risk.  So we tactically adjust our short exposure, and we expect to generally target exposure in those separately managed accounts between 50 and 100% short.  It can be as low as zero, but typically, between 50-100%.  Our current short exposure is 60% of account equity. 

With the market at records highs, and in the face of deteriorating fundamentals, we see extreme market downside risk, but we know better than to try to predict the market top, to call the market top, and we fully expect an ongoing extraordinary environment, with elevated risk on the short side.  

As always, we don’t recommend placing aggressive bets against the stock market, but we can and we do believe the risk of a market accident is quite high and there are opportunities there.  So myriad risks – we’re talking about speculative bubbles, market structure, economic risks, geopolitical risks – all of these risks (inaudible) _00:04:26_ to be short they are going to demand a disciplined approach to risk management. 

I want to repeat what we stress in every call, that remaining 100% short all the time, as most short products are structured, is a bad idea.  It is what we would call risk indifference.  Risk indifference is a problem, especially on the short side, in very uncertain environments.  We structure Tactical Short to ensure that we have the flexibility to navigate through even the most challenging market conditions -(inaudible) _00:04:57_ this is one of those conditions, markets continue to reach higher.  Being fully short was rewarded late last year.  But the cost of a risk indifferent

Approach has become very apparent as you look at the first half of 2019 in contrast to Q4 of last year. 

Let’s give you an update on performance.  Tactical Short accounts, after fees – this is for Q2 – declines 2.86% during the quarter.  The S&P returned (inaudible) _00:05:35_ 4.3% positive versus 2.86% negative.  Tactical Short lost, if you’re doing the math on that, it’s basically two-thirds of the inverse of the S&P’s return, so 66% of the S&P’s return during that quarter.  As for one-year performance, Tactical Short after fees returned negative 7.13% versus the positive 10.41 positive return in the S&P 500.  

For helpful comparison we regularly track our performance versus three of the actively managed short fund competitors.  The first is Grizzly Fund.  They lost 4.07% during Q2, and for one-year performance Grizzly returned a negative 12.6%.  Ranger Equity Bear Fund lost 6.79% during the second quarter, and 18.21% for the past year.  Federated Prudent Bear Fund, the second quarter loss was 4.61 for the quarter, 12.12 in the last four quarters combined, the last year.  

For the past year Tactical Short significantly out-performed these three bear funds.  This goes back to, again, moderating our exposure, being willing to increase where we see needed, and decrease where we also see needed, the short exposure, and tactically manage that exposure.  For the quarter, Tactical Short, on average, out-performed these three competitors by 230 basis points and over the past four quarters Tactical Short, on average, outperformed those competitors by 718 basis points. 

Since we took on our first account April 7, 2017, the inception, through the end of June in 2019, Tactical Short has returned a negative 11.98% versus the positive 30.38% return for the S&P 500, again, on average out-performing our competitors by 1747 basis points.  

With the wrap-up on performance, I want to quickly move toward Doug’s comments and will do some unpacking for you on these collapses in yields globally.  

Doug:  Thank you, David.  Good afternoon everyone.  Thanks for being on today’s call.  I’m just really excited for the opportunity to discuss such a fascinating environment.  I will begin with the discussion of short exposure, portfolio composition, and our risk management focus, and that is a focus that has, again, differentiated our approach from others, and then dive into the macro backdrop.

Our Tactical Short strategy began the quarter with targeted short exposure at 60%.  Exposure was reduced to 56% by mid-April, with trade war risks escalating, financial conditions beginning to tighten, and China instability intensifying, we increased exposure to 66% by late May.  Short exposure ended the quarter at 64%.  Because of the ongoing high-risk environment for shorting, a short in the S&P 500 ETF was the only short that we had on during the period.  While we expect to use tactically managed listed put option exposure at times, it could be an important component of our strategy at times, we again did not trade an option during the quarter.  

Since inception, we have yet to transact an options trade.  When we began Tactical Short back in 2017 our plan was to be patient and disciplined with our options, but I did not anticipate holding off purchases for this many quarter.  I also didn’t anticipate the market going almost 30% against us.   

I believe we are heading into what may present itself as a very good opportunity to purchase put options in the coming months, but we will remain disciplined.  I know some investment managers regularly purchase put options hoping to catch an occasional market decline.  The problem is, once you start buying options and you watch them mature worthless, it becomes increasingly difficult not to keep buying them.  After repeatedly losing money on options, the fear of missing out during a big market decline becomes intense.  We just want to avoid playing that game.  We will look for particularly appealing put option opportunities, accepting that we might miss out. 

We have a unique approach to managing short exposure and the first half continued to illustrate why we do things the way we do.  As David mentioned, we outperformed the three competing bear funds by an average of 230 basis points during the quarter.  For the first half Tactical Short out-performed by an average of 926 basis points.  Two of the three funds lost more than 100% of the S&P’s return during the quarter with the three funds, on average, losing 120% of the S&P’s return.  So far in 2019 one of the funds suffered a draw-down of 24%, and another of 22%.  

It remains our view that the market has been in a topping process, one that has evolved into a quite protracted market top at that.  Major market tops encompass myriad uncertainties, market indecision, and volatility.  We believe we are nearing a momentous market inflection point, the culmination of a multi-decade cycle.  I will tell you that as a manager of short exposure, I’ve never enjoyed playing market tops.  Two words come to mind – frustrating and exhausting.  Markets tend to turn highly erratic and whimsical as they completely detach from underlying fundamentals near the cycle’s end, and the process can drag on and on. 

As fundamental prospects deteriorate, the marketplace attracts more shorting and hedging activities.  That’s just the way it works.  And this ensures heightened volatility, a propensity for short squeezes and unpredictable sector rotations.  We have seen all of those recently.  

This is exactly the type of challenging environment that is making life on the short side extraordinarily difficult.  At the same time we believe market downside risk is extreme, the most I’ve seen during my career.  So, in short, our strategy has been to provide downside protection for investors while avoiding trouble.  We have been positioned tactically for a prolonged and challenging market-topping process.  I am specifically not trying to trade this market, believing a trading-focused strategy would entail too high a probability of disappointing results.  

Tactically, that means managing exposure carefully and avoiding the risk of being caught in short squeezes and being caught short out-performing sectors in a rising market.  So by default, in such high-risk market backdrops we gravitate to the S&P 500 index where our short risk is relatively well-defined. 

Let’s shift to the environment.  The 2nd quarter was extraordinary.  Global markets were unsettled throughout the period.  Building on 1st quarter momentum, U.S. equities posted solid April gains.  Risk aversion began to take hold in early May.  Chinese stocks reversed sharply, sinking almost 13% in ten sessions.  This string of Chinese corporate defaults weighed on market sentiment with contagion effects beginning to pressure the emerging markets.  Powell’s early May suggestion that inflation shortfalls were transitory aroused market memories of the tone deaf Fed from December, and then U.S./China trade negotiations broke down mid quarter. 

The S&P 500 declined 5.6% in May as equities saw the rally stumble, yet something much more intriguing was unfolding in global bond markets.  Ten-year treasury yields sank 38 basis points during the month of May, nearing the low yield going back to 2016.  German Bund yields dropped 22 basis points to a record low of 21 basis points.  Japanese JGB yields fell to negative 10 basis points and Swiss yields ended May at negative 51 basis points.  At that time, sinking yields were explained in the marketplace by the risk of an escalating U.S./China trade war, slowing global growth, and weakening inflation trends. 

Then June saw a reduction in trade tensions capped off by the Trump G-20 meeting and resulting truce.  June posted a surprisingly strong 224,000 gain in U.S. payrolls as economic data turned less concerning in the U.S., and globally.  Crude and commodities saw their prices rebound strongly in June.  Meanwhile, the global yield collapse ran unabated.  

As frustrating as it was on the short side, it was a fascinating quarter from an analytical perspective of the global credit bubble and my overall thesis.  I view the extraordinary surge in safe haven bonds, the collapse in yields, along with the surging gold price, as important corroboration of a thesis of vulnerable bubbles in mounting global financial fragilities.  German bund yield went on to sink to a record low 40 basis points, with Swiss ten-year yields down to a negative 69 basis points, and Japanese yields at a negative 18 basis points.  As David noted earlier, this is all unprecedented.  

At a recent low of 1.95%, ten-year treasury yields were down almost 150 basis points since last November.  Italian yields were down over 100 basis points just since the end of May.  Amazingly, Spanish and Portuguese yields dropped all the way down to 20 and 28 basis points.  Greek yields were down 150 basis points in just six weeks to 2%.  I think we have all become somewhat numb to incredible market dynamics.   

Having been involved in the markets for some time now I seriously doubt sovereigns yields would drop precipitously to unprecedented lows without some major, festering global issue.  Moreover, periphery debt such as Italian and Greek bonds would not experience such dramatic collapses without a significant market dislocation.  The collapse in yields recalls 2007’s second half when treasuries diverged dramatically for an equities market, rallying to all-time highs.  

It is also worth recalling that treasuries suffered another bout of sinking yields in 2011 ahead of the 2012 European debt crisis.  Bond markets have a knack for sniffing out mounting risks and unfolding crises.  It is my view that global bond yields are signaling serious impending instability, and I believe China will be at its epicenter. 

David:  Doug, just to comment on that, it is clear that there has been a massive divergence between the signals from the bond market and from the stock market, and you reference the sinking yields of 2011 ahead of the 2012 European debt crisis.  This is actually pretty normal for bonds to move before stocks do.  Stock investors are not credited with being at the top of the stack in terms of intelligence.  They usually get things last.  The bond market moves first.  I just wanted to throw that out.

Doug:  Yes, excellent point, David.  Thank you. 

 Every major bubble reaches a point of no return where excesses have gone to such extremes that some level of crisis is unavoidable.  I refer to the terminal phase of bubble excess.  On the financial side, systemic risk rises parabolically with the surge in the quantity of credit of rapidly deteriorating quality.  Invariably, too much of this suspect credit is held by highly-leveraged institutions and speculators, while market dysfunction ensures resources are poorly allocated. 

On the real economy side there is a proliferation of uneconomic enterprises, and deep structural maladjustment.  The best policy-makers can hope for is to provide some support while allowing air to come out before the bubble inflates to dangerous extremes, but especially in today’s environment no policy-maker is willing to take the punchbowl away, yet efforts to sustain the bubble risk catastrophic damage to the underlying financial system, the currency, and the economy.   

China experienced a faltering bubble episode in late 2015, early 2016, but aggressively reflationary measures resuscitated China’s credit and economic bubbles.  Beijing then moved to somewhat reign in credit excess last year, and their bubble again began deflating.  China financial and economic fragility is at the epicenter of the 4th quarter global risk-off dynamic that was reversed by the Fed’s dovish U-turn.  Facing sinking markets and weak economy while in heated U.S. trade negotiations Beijing once more resorted to the accelerator.

It is worth briefly highlighting China’s first half credit data, at least the general numbers.  Total aggregate financing, and that is their measure of total nongovernmental system credit, increased 1.921 trillion dollars during 2019’s first six months, and that is fully 31% ahead of first half 2018 growth.  Total aggregate financing ended June at 31.2 trillion, up almost 11% over the past year.  Even in the face of historic credit growth ominous cracks have developed in China’s financial system.  In late May Chinese regulators took control of Baoshang bank, the first government bank seizure in 20 years.  Even more dramatically, regulators imposed losses of up to 30% on some large institutional depositors and debt-holders.  

These haircuts immediately raised a question for a marketplace that has for years boomed on faith in this implicit Beijing government guarantee of virtually the entire Chinese financial system.  After the Boashang takeover, dislocation unfolded in part of China’s 10 trillion dollar money market complex.  Short-term funding rates, that is, repurchase agreements, banker’s acceptances and interbank loans for small and mid-size banks, spiked higher as investors retreated from riskier segments of the marketplace.  

Market participants spoke of a loss of trust and fear of an unfolding liquidity crunch.  We saw enormous liquidity injections from the People’s Bank of China and also state-directed support from the large financial institutions, and that restored calm, recalling how calm was repeatedly restored in the U.S. between the initial June 2000 subprime eruption and the onset of a full-fledged crisis some 18 months later. 

I know conventional thinking has it that the 2008 crisis was avoidable, if only Lehman hadn’t been allowed to fail, had the Fed been more aggressive in cutting short-term rates, perhaps even employing QE earlier.  But this is specious analysis.  

David:  Doug, I think it’s worth noting that we could, in retrospect, have already had our Lehman moment as we watch things deteriorate with Deutsche Bank setting up a (inaudible) _00:23:05_ bad bank here in recent weeks to shuffle close to 80 billion dollars’ worth of garbage paper into that they don’t want to (inaudible) _00:23:13_ mark-to-market.  Going back to Lehman and your point on maybe they should have bailed out Lehman – at least that is the contentious argument – at least as a trader, they say the first loss is the best loss.  And you look back in time at the opportunity to bail out organizations and it doesn’t always go the way you think it does.  Overend Gurney was an institution in Britain back in the 1800s the size of J.P. Morgan, the most important financial institution, probably, in all of London.  They had to be bailed out in 1857.  Guess what happened?  They were gone.  They were extinct in 1866.  So again, the first loss being the best loss, I think that you are right.  Had they bailed out Lehman, it’s not necessarily the end of the story.

Doug:  Definitely not, David.  The problem was, in 2007 there were trillions of mispriced securities and derivatives – trillions.  We had inflated home prices that were unsustainable, and there were hundreds of billions of festering problem loans.  Years of mispriced and misallocated finance had created deep economic structural maladjustment.  That’s the way bubbles work.  There were enormous speculative excesses and leverages that posed great systemic risk.  Both financial and economic circumstances were unsustainable.  Excesses from the long boom had made crisis inevitable.  The Lehman collapse simply brought things to a head.  

As we ponder today’s bond yields it is important to note that the bond market back in 2007 had discerned the predicament long before Lehman lost access to repo financing.  While down-played at the time, the June 2007 subprime eruption was the beginning of the end of the mortgage finance bubble.  The hedge funds moved to cut risky mortgage exposure, and the marginal subprime home-buyer almost immediately lost access to finance, and this commenced a tightening of credit that began at the periphery and ended in a systemic crisis at the core of U.S. market-based finance.  

Today, the periphery of China’s credit system has experienced a meaningful tightening, that over time will reverberate throughout the system.  Beijing has dictated that major state-directed banks take up the slack while this just ensures these bloated institutions add high-risk late cycle credit to their already highly vulnerable loan portfolios.  

Chinese finance now faces (inaudible) _00:26:18_ counter-party concerns over scrutiny of small banks, non-bank financial institutions, lower-rated local government financing vehicles, trust companies, and other shadow lenders.  Higher risk borrowers now face tightened credit conditions.  This is very important.  Of China’s almost 2 trillion dollar first half lending, now much went to finance overpriced department purchases and how much was directed to uneconomic negative cash-generated enterprises?  I will assume much of it.  

Over the past year, China’s debt load has increased to 303% of GDP from 297 as each renminbi of credit generates less of a boost to economic output.  China’s already dire circumstances are compounded by the unfolding trade war with the U.S. and we see all the headlines.  American companies have begun the process of sourcing products outside of China while manufacturers operating inside China are looking to relocate to more economic venues for supplying their U.S. customers.  Trade deal or not, these two countries will reduce inter-dependencies.  

China’s system debt is on a pace to expand 4 trillion this year, an incredible amount of credit, a credit boon that is masking festering financial and economic structural issues.  I believe China’s officials recognize risks associated with such lending excess, yet while they are under threat from the Trump administration their near-term priority has been economic stabilization.  When their bubble succumbs, they have a convenient scapegoat. 

China’s bubble is past the point of no return and I believe crisis is unavoidable.  Systemic risk now rises exponentially, raising the specter of a crisis of confidence in Chinese finance and the Chinese currency.  Importantly, Chinese finance evolved to become the marginal source of finance globally and the Chinese economy the marginal source of demand globally.  One cannot overstate ramifications for a crisis-induced plunge in China’s credit and economic growth.  

Many people aren’t aware of this, but while China runs a huge trade surplus with the U.S., China has deficits with many EM economies.  Chinese investment has been a major source of global growth and Chinese tourists and students spend lavishly around the globe.  And from corporate MNA to home-buying, there has been a powerful flow of money from the Chinse credit system to global asset markets, and that is all alarmingly reminiscent of the flow of U.S. bubble finance to the world in the late 1920s.  

It is my view that global bond markets have sniffed out an unfolding accident in Chinese credit, a highly destabilizing crisis of confidence that would be a catalyst for major market instability and bursting bubbles around the globe.  From my perspective, risk is high for a global crisis much beyond the scope of what we saw in 2008 and I believe that is what collapsing yields globally are signaling. 

Markets now anticipate aggressive monetary stimulus, including multiple 29 rate cuts from the Fed and a restart of ECB QE only months after concluding its latest 2.6 trillion dollar program and the prospect of concerted open-ended QE has generated major market price distortions.  Why buy German bunds at negative 40 basis points?  Slovakia bonds at 5 basis points, or Italian bonds at 1.6%?  They are bought either because buyers expect to sell them to the ECB at even higher prices or they plan on holding them dearly to survive a crisis.  

David:  Doug, I think it is worth remembering that in the 2008 and 2009 timeframe, liquidity was scarce, and that is what created many of your significant very stressful financial moments.  When you have a liquidity seizure, the question is, what assets do you have that you could borrow against, and government bonds of any kind are better collateral to borrow against.  So some of this buying may be very smart save haven buying.  Survival of a crisis is one thing, but you put yourself in a position to be able to borrow against a “quality asset” and keep in mind that could be a collateral play, as well. 

Doug:  Yes, that makes a lot of sense, David.  Thank you.  

Let me digress just a little bit here.  The expectation of unlimited and completely price-insensitive central bank buying has created unprecedented distortions throughout global markets.  We’re talking about the foundation of international finance, sovereign debt, so why not aggressively employ speculative leverage throughout global bond markets, and why not lean on risk parity strategies, these sophisticated hedge fund strategies with their levered equities and bond holdings able to weather any market storm?  

Now, let me pose a most pertinent question.  How much speculative leverage has accumulated over recent years all around the globe?  It is a very important question. 

David:  It’s a big question.  Doug, one of the things that comes to mind, too, is that with these sort of bullet-proof risk parity strategies, they weren’t that bullet-proof if you look back at the 4th quarter.  It was no picnic for risk parity, and in fact, as you look at one of the largest guys in that space, Dalio, of late he is more interested in gold, and I think there is a lot that can be inferred from what he anticipates on the horizon, taking a keen interest in gold at this point.  But risk parity – weathering the market storm?  I don’t know, Q4 didn’t shine a bright light on it. 

Doug:  No, wait until interest rates move up while equities move down, and those strategies will be under pressure.  As the new chairman, I do believe Powell preferred shifting to a strategy of not coming quickly to the market’s defense, to allow the markets to begin the process of standing on their own.  This would explain the Fed’s widely criticized December 19th rate increase in the face of unstable markets, but the rapid onset of acute market fragility forced the dramatic June 4th dovish U-turn that quickly was adopted by the global central bank community. 

From the December experience, central banks came to a better understanding of the degree of market vulnerability out there.  Meanwhile, markets move than ever recognized they held incredible sway over central banks.  Collapsing yields have provoked the latest iteration of new-age central bank activism, the so-called insurance rate cut, Powell’s “an ounce of prevent is worth a pound of cure.”  Markets, of course, have become abundantly confident that aggressive stimulus will be unleashed ahead of any onset of crisis dynamics.  So the question becomes, if QE purchases are set to commence at the first indication of trouble, why not use sovereign debt as a hedging vehicle to protect against declining risk markets?  Why would you use put options and other equity derivative strategies when bond call options and fixed income derivative provide downside risk market protection while profiting handsomely, even as equities rise to records.  

The point is, I believe global bond markets have experienced a dislocation fueled by self-reinforcing aggressive use of leverage, huge flows into bond and fixed income ETFs and unprecedented derivatives-related buying.  The sellers of myriad bond call options and more sophisticated fixed income derivatives have been forced to aggressively buy bonds to hedge exposures in a rapidly rising market, and anyone caught short bonds has been in a panic to reverse their trades. 

This global market dislocation has surely spurred enormous amounts of additional speculative leverage, in the process creating self-reinforcing liquidity excess, along with the perception of endless marketplace liquidity.  This is where it really gets intriguing and I believe where analysis sheds some light on an extraordinary global market environment.  Risks are accelerating.  That is China’s vulnerable credit system, the Chinese economy, global trade wars, protectionism, weakening growth dynamics across the globe, and heightened EM fragilities.  

If you look at just the past year we have witnessed Argentina’s currency collapse 35%.  Turkey has faced intense currency and bond market pressure.  There are widening cracks in India’s credit system, and Mexico is hearing recession, to name just a few EM issues.  Yet some of this year’s strongest returns have been with 100-year Argentine, Mexican and Petrobras bonds.  India’s yields have sunk to 2016 lows.  Amazingly, Turkey is still able to tap international bond markets and already at 168 billion, only midway through the year, EM bond issuance is at record pace, and with record low yields.  

So why the panic buying of bonds that could very well prove most vulnerable to the unfolding environment?  Well, because market dislocation has created 13 trillion of negative yielding safe haven bonds along with a surge of excess liquidity.  Amazingly, it has been a case of too much hot money chasing too few global bonds, and there are plenty of global bonds.  

Despite the fundamental backdrop, it has been a veritable flood of money into some of the riskiest segments of global markets, emerging markets, junk bonds, structured finance, and some equity ETFs.  These days, the marginal borrower has virtually unlimited access to cheap finance.  It recalls the summer of 2007 and the unrelenting boom in mortgage excess, the leveraged lending and MNA boom.  Chuck Prince from City Group’s infamous “still dancing” quote – well, strange things happen at end-of-cycle speculative blow-offs.  There is just so much money being made it becomes a case of disregarding risk is imperative to make money in the markets, and we have certainly seen a disregard for risk.  

The problem is, though, today’s extraordinary liquidity backdrop is highly unstable.  The dance party could come to an abrupt halt.  The liquidity bonanza created during risk-on, risk-taking and leveraging, will disappear come risk-offs, de-risking, and de-leveraging.  

David:  It also makes sense to me, Doug, that the surprise for the retail investor is going to be the use of these ETFs and passive investment vehicles to gain exposure to particular assets.  The underlying assets, themselves are not as liquid as the ETFs would suggest.  So the assumption of ETF liquidity can also shift and be turned on its head pretty quickly.  

Doug:  Yes, and that could be a very important dynamic.  If we look at the global environment today, virtually any company or country can tap the booming global debt markets, but today’s marginal borrowers are highly vulnerable to a bond market reversal.  Just last week we saw yields jump 25 basis points in Spain, 21 basis points in Greece, and 15 basis points in Germany and France.  Even ten-year treasury yields were up a quick 17 basis points from lows.  

When we look at risks out there, there could be the risk of a surprising back up in yields.  Markets had to digest June’s stronger than expected payroll data.  Inflation and retail sales were also stronger than expected.  The U.S. economy should receive some stimulus from record securities prices, low mortgage rates, and several months of quite loose financial conditions.  Things get interesting if the treasury market starts to focus on massive supply and waning foreign demand and the potential for up-side inflation surprises.  

It is worth noting the bid to cover ratio at last Tuesday’s three-year auction was the weakest in a decade.  But the bottom line is a Fed cut later this month appears a near certainty.  So for now, global bond markets have been content to look through positive data and focus instead on mounting risks and forthcoming monetary stimulus.  So while People’s Bank of China liquidity injections have calmed China’s money market, I expect this calm to prove fleeting.  Crises often erupt in the money market where dramatic consequences arise from even a subtle loss of confidence.  There is just little room for error in a market where investors have near zero tolerance for risk.  Runs can be unleashed when the perception of safety and liquidity is shaken.  

Clearly, huge risks continue to accumulate in what has become China’s massive money market, losses are mounting throughout China’s banking and financial systems, and Beijing will not want to shoulder all the pain.  The process of diluting Beijing’s implicit guarantees and shifting risk to the market place has commenced.  This will induce heightened risk aversion, including in China’s susceptible money market. 

Thinking back, it took 18 months from the initial subprime eruption to the 2008 breakdown, so the timing of a Chinese crisis remains unclear, but I do believe the clock has started.  Financial conditions in the money market have tightened and there will be more financial players that find themselves in difficult predicaments.  Everyone believes Beijing will support ongoing growth with whatever stimulus is required, yet I believe global bond markets confirm my analytical thesis.  We are now very late in the game.  Stimulus, at this point, only exacerbates excesses and imbalances, ensuring a more problematic Chinese and global crisis. 

I have been closely monitoring bubbles going back to Japan’s late 1980s experience.  And it is always the same.  Everyone is happy to just go along and ignore the bubbles while they are inflating.  Bubble analysis, by its nature, will appear foolish for a while, sometimes a long while, and especially ludicrous during the late cycle manic phase.  But bubbles inevitably burst and there is no doubt that China’s historic bubble will burst, and I expect this will prove the catalyst for faltering bubbles across the globe including here in the U.S.  

The obvious transmission mechanism will be through the securities markets.  Global markets have become highly synchronized across assets classes, and across countries and regions.  Market-focused monetary stimulus has become highly synchronized, essentially creating one singular comprehensive global bubble.  But I will note a particular circumstance that could catch global markets and policy-makers by surprise.  Note, a dislocation in China’s repo securities lending market that reverberates throughout repo and derivatives markets in Asia, Europe and the U.S.  This latent risk, in itself, could help explain the global yield collapse in market expectations for aggressive concerted monetary stimulus.  When Chairman Powell these days repeats global risks in his talks I think first of global repo markets, global securities finance, and global derivatives.  

And I doubt it will take much for today’s risk-on dynamic to shift to risk-off.  We saw in the 4th quarter how quickly things can begin to unwind, and this year’s notable excesses have only worsened fragilities.  If there is as much speculative leverage globally as I believe there is, markets are highly vulnerable to de-risking and de-leveraging developing into globalized market illiquidity.  Global markets have become tightly interdependent, global derivatives trading closely intertwined, and marketplace liquidity highly interconnected.  I believe global bond markets and central bankers are today on the same page, in theory, a seizing up of global markets.  

Importantly, the more intensely market succumb to speculative melt-ups and upside dislocation, the greater the likelihood that market reversals unleash problematic illiquidity and dislocation.  Bubble markets have a history of going from record highs to serious trouble in a short period of time.  Just last year, October’s record highs were not many weeks from December’s market swoon.  Markets peaked only weeks before the 1987 crash, and the great crash of 1929.  

It is also typical for a final speculative blow-off to end the cycle even with fundamental deterioration well under way.  We saw this dynamic in Q1 2000, and again in the 4th quarter of 2007.  Contemporary finance and policy-making are structured to support asset inflation bubbles.  The problem is, things function poorly in reverse.  Markets have been in upside dislocation, fueled by speculative leverage, hot money flows, derivative-related buying and the like.  

We live in this age of near zero rates, whatever it takes QE, index ETFs and passive investing, speculative leverage, algorithmic trading and derivatives.  It all means, to make money you just ignore risk and follow the trend.  But when sentiment shifts, we see risk aversion, de-leveraging, outflows and derivatives selling, we will quickly see serious liquidity issues.  Central banks’ efforts to hold risk-off at bay by back-stopping liquidity, abolishing bear markets and recessions, have incentivized risk-taking and leveraging, creating only greater market distortions and fragilities.  

The global bubble inflation has gone to precarious extremes while central banks are left with depleted ammunition.  So they have adopted this notion of using their limited ammo early and aggressively to safeguard against a bigger problem later.  This is dangerously flawed doctrine and I believe the global bond yield collapse is signalling this approach will prove highly unsuccessful. 

David, back to you.

David:  Doug, thanks for your comments.  We’re going to move to Q&A.  There have been a couple of questions that have come through the Internet portal which I have addressed in writing, but I will go ahead and bring them into the conversation here in a little bit, as well.  Starting with the ones that were submitted to us ahead of time I will begin with this one: 

We have almost 50% of our retirement portfolio invested in the residential real estate market.  The balance is precious metals, hedge funds, and cash.  How could using a Tactical Short strategy benefit us or reduce the risk of a market crash in our retirement?

David:  A couple of things to note there.  Obviously residential real estate is not particularly liquid, so what we are really talking about is strategic decisions that can be made with the liquid part of your portfolio, precious metals, hedge funds, cash, and how Tactical Short would complement that.  I see one particular risk there, precious metals and cash having their own forms of optionality and almost an insurance component with the metals, themselves.  Hedge funds, obviously, come in many flavors – more than 31 flavors (laughs) – probably 3000 or 8000 or however many hedge funds are still around.  But what we find with most hedge funds today is that they are leveraging the most popular momentum trending stocks.  So if Apple, which happens to be one of the top holdings for a hedge fund, whatever happens to be trending doesn’t have to have fundamental merit (inaudible) _00:48:57_, it can be just price movement, and we see a lot of hedge funds gravitating toward that, which means that as goes the market, so goes performance.  

I would suggest that Tactical Short is almost a perfect protective sleeve to run alongside whatever market exposure you have in equities to reduce your downside, and to do that intelligently.  As Doug has mentioned, we are very different in this respect from our competition because we can moderate, and whether it is a QE announcement or further rigging of prices within the bond market, guess what?  We can adjust our strategy and reduce risk in the portfolio.  And when we do see market crash and things begin to cascade within the securities market we can obviously increase our short exposure, as well.  So I look at what we do as something that does, in fact, reduce your retirement market crash risk pretty considerably. 

Doug, I’m going to shift this next one to you:

As price signals have been distorted so much, what does the popping of the passive investing bubble look like, and how does the average person protect oneself?  New to the Tactical Short strategy, have been reading the Credit Bubble Bulletin for about two years now.

Doug:  I like this question.  The passive investing bubble is basically, ignore risk, have faith in central bankers, and buy and index ETF for the long term — it could not be any easier than that.  But I think this is just part of the manic stage here.  At some point risk won’t be ignored.  Faith in rate cuts and QE will be shaken, and there will be a run on some of these ETFs.  

I worry most about ETFs that invest in illiquid securities – David, you touched on this – junk bonds, structured credit, small cap stocks, for example.  This is just the latest of Wall Street alchemy, the art of transforming risky illiquid securities into perceived safe and liquid money-like ETF shares, at some point there will be big outflows and problems finding buyers for the underlying securities.  These ETFs will need to sell to fund outflows.  

I think it gets really messy and the marketplace shifts back to appreciating risk and the value of active management.  What does the average person do to protect oneself?  I would say it is time to pare back on market risk.  It is difficult to do at this stage when the market just seems to go up constantly, but I say pare back on market risk, pay down debt, and hunker down. 

David:  The next question, Doug, is moving toward this point – why be short equities?  It starts this way: 

Bond stocks, pulling in opposite directions, both betting on rate cuts.  Short term you have equities still moving higher.  On bad news doesn’t matter (inaudible) _00:52:21_ and no matter how bad the debt is, fundamentals just aren’t today’s story.  With liquidity being the key, with the Fed looking to extend the business cycle, which they have done since the start of the year, why be short equities?  Fed saves the day, maybe you have dollar pressure.  Isn’t that kind of another 2015-2106 all over again?

Doug:  Fair question.  I will say liquidity can be very fleeting as we saw as recently as December.  The question, why short equities in this environment?  Let me tweak the question just somewhat and ask it a little differently.  Why would someone want to hedge equity risk today?  That’s the relative question.  As I tried to explain in my talk, I believe market downside risk is extreme.  My view is history’s greatest bubble is at great risk.  Go down the list – China, EM, trade wars, geopolitical and so on. 

And more specific to the U.S., and I didn’t really address this yet, I believe we are at the end of a protracted policy-induced boom, and once again, finance here in the U.S. has been mispriced and misallocated, maybe not to the extent of China, but significantly.  And we have record securities values to GDP which is a ratio I follow.  We have tech bubble 2.0, commercial and residential real estate bubbles, in so many markets, a proliferation of uneconomic businesses, massive fiscal deficits, current account deficits, and so on.  There is much greater financial and economic risk than is commonly believed.  I’m just 100% convinced of that.  

And I believe market structural issues are greater today than even in 2008.  I will be the first to admit that it appears perfectly rational to buy stocks for the long term right now, and shorting, candidly, appears hopeless, right?  That’s what everybody believes right now.  Well, that’s just what one would expect at a historic market top.  So we’re going to continue to work hard and do what we do and be prepared every day when we come in. 

David:  That notion of heading risk is, I think – I appreciate the way you framed that because it is not a question of speculating on the short side, with the likelihood of further Fed policy intervention, it is when things get to extremes do you take risk of or do you just kind of blindly move forward as if the party will never end?  Hedging is one form of doing that.  And certainly, for tax considerations, that can be a very important decision where perhaps you don’t want to liquidate but you do want to avoid as much downside.

Next question, Doug, is:

Given account values, (we talked about performance earlier) down the current short position of 60% of the account value, the market would have to fall 30% to break even.  What are your views on increasing the short percentage, and what would cause you to do so?  What is your S&P target or percentage drop on the short side in terms of fundamental value?

Doug:  Let’s say we wake up tomorrow morning and we find out that China invaded Taiwan and a war has begun and the market is down 30% at the open.  At 60% short we would make 18%.  So that is one scenario, but that is an unlikely scenario.  The way we look at it is, we adjust our short exposure over time and along the way of a market falling 30% we’re going to have ample opportunities to not only increase our short exposure but the trade puts and change the composition of short exposure, etc., to hopefully profit a lot more than we would with just an immediate 30% drop in the market.  So I will start out with that.  

I will also say, we would not have introduced the Tactical Short strategy had we not believed a major protracted bear market was in the offing.  I don’t have a -specific downside S&P target but when major bubbles burst it has not been uncommon to see huge price collapses and that could be 60%, 70% or even 90% declines.  I could certainly see 2008 lows taken out.  More generally, throughout my career managing short exposure, and that’s working to provide an effective hedge, the focus is always to try to have more short exposure when the market environment is favorable for shorting, and less when it is unfavorable.  With the objective of making greater returns, the objective is always to try to make greater returns when the market is declining and the losses that we would suffer in a rising market.  I would like to think we could generate decent returns even in a flat market, and this can be accomplished by having short exposure in the right places, some savvy trading decisions, and some good timing in put options.  In a sustained down market we will have a lot more short exposure then than we would have today.  

The key, though, for what we are trying to accomplish here, would be to compound returns over time.  In a multi-year bear market, hopefully, we will put together a string of good years.  We’ll have to play some good defense during inevitable rallies, but the good defense will create opportunities to play offense and take advantage of market swings.  But so far the focus has been to position short exposure to get through a market-topping process without outsized losses.  It has just gone on so much longer than we would have thought, but that’s reality, and that’s how we’re positioned.  It is not indicative of how we will play a short exposure in indifferent, more favorable market environments and we will look to adjust both the amount and composition of short exposure.  Hopefully, that provides a little color there.  

David:  And this one:

How much steam is remaining in the S&P 500 if Powell cuts in July?  Can they sustain the markets until the election?  Powell is in Europe.  Is he getting orders from the BIS in Basel?  How do you sort through the mixed messages Trump sends regarding China, the Fed, tariffs, Judy Shelton, Boeing does fairly well this week, Deutsche Bank goes up?  It seems like in the past, as this question reads, they would have gotten slaughtered, and the ability to trust anything regarding markets – challenging.  McAlvany and Noland are equipped to analyze markets better than anyone.  How do you remain so positive given the difficulties?  Thanks, Kevin.

Doug:  Thanks for that question, Kevin.  As you have heard me say too many times before, things get crazy at the end of a cycle, and we are seeing crazy everywhere, certainly, including Washington.  So it’s difficult to make sense of crazy sometimes.  As I mentioned earlier, market price is detached from underlying fundamentals, so there is no real surprise there, and that is one of the reasons why we are not out there aggressively shorting individual company stocks because this is the way it works.  It’s always a challenge. 

As far as Powell receiving orders from the BIS, actually, at times the BIS has even been skeptical of some of the benefits of aggressive monetary stimulus, but I do believe global central bankers now communicate constantly and coordinate their approaches to monetary policy, again, because everything is so tightly intertwined here.  Behind the scenes there must be significant nervousness in the central bank community for them to resort to swinging to such dovishness.  

How much steam is left?  I don’t think too much, but I’ll tell you, my life would be a lot easier if I could predict the markets.  But I know I can’t.  

And you also asked the question, so I’ll be brief on this, how I can remain positive?  Well, believe it or not, I’m a positive, optimistic person.  I am also quite confident in the analytical framework bubble thesis.  I started on the short side almost 30 years ago, so this is my third major up-cycle I’ve had to persevere through, so I know what to expect.  I called the global finance bubble the granddaddy of all bubbles early on, so I’m not surprised the excesses have gone way beyond those from the previous bubble.  I’m just very confident in the analysis that the damage from the bursting bubble is commensurate with the excesses from the preceding boom, so it is not difficult for me to envision the unfolding opportunities on the short side, and to stay highly motivated.  But Kevin, as always, thank you for your score.  

David:  I think it is only fair to say, Doug, that having endured three of those up-cycles, what came at the end of each of those cycles.  The analysis was correct, the movement in the markets did occur.  There was pain endured for an interim period, but ultimately the thesis proved out correct.  And so, yes, timing is tricky, but the mathematics of it and the impossibility of maintaining momentum indefinitely to the upside, that is what we know from market history, whether you want to go back 50 years or 500 years. 

Doug:  Exactly.

David:  Next question:

In light of a new IMF paper, Enabling Deep Negative Rates, can we rule out meaningful declines in physical assets such as real estate and land prices?  

And yes, I made mention of the Enabling Deep Negative Rates.  This was a paper published in April by the IMF.  I thought it was a very helpful paper because it demonstrated the out-of-the-box thinking within academic circles for how you can control rates, not just slightly below zero, as Doug mentioned, we have maybe the Swiss at the most negative levels, but we’re talking 2, 3, 4, maybe even 5 percentage points below zero, and what are the implications for the banking system, what are the implications for savers going forward (inaudible) _01:03:18_? Fascinating paper as it explores how to play chess in that environment.  And this is policy-makers trumpeting their views as to how they would play that game.  So I think it is worthwhile reading if you haven’t read it. 

Back to the question, I’m sorry:

Can we rule out meaningful declines in physical assets such as real estate and land prices?

To me, the more aggressive the monetary policy, it seems to me the greater risk you have with stress and strain on the currency, itself, and I think, ultimately, that factors positively for physical assets.  That factors positively for real estate, land prices, not necessarily leveraged real estate, but if you’re talking about real things, productive properties, I’m not sure that you would have a downside, per se, because again, what is a 5% return, or an 8% or a 10% return on a real estate asset look like relative to a negative 5% in a cash deposit.  I think your real estate looks pretty good at that point.  So yes, I wouldn’t be as concerned with real assets.  Paper assets – again, it depends on what preceded that cut in the deep, deep territory.  They won’t go there.  The central banks of the world and the Fed here in the U.S. won’t go there unless they have to and in that case it would be a policy response, probably in light of precipitous decline to those other assets. 

The next question is:

Do you expect the coming recession as deflationary when compared to gold as opposed to fiat currencies? Are various asset prices expected to do worse when compared to gold, even if they might rise relative to fiat?

The currents of inflation and deflation are, I think, currents that swirl together, and one of the things that is perhaps a lesson learned from the 2007-2008 timeframe, because I recall much of the conversation ending with complete system wide deflationary collapse.  What we did see was deflation in particular asset classes, in particular sectors, with your asset-backed securities and your mortgage-backed securities being right in the middle of that.  Not everything circled the drain to the same degree.  So I think it’s worth going back to inflation and deflation, that scenario analysis.  It doesn’t have to be strictly one or the other.  

Where gold will show its metal, so to say, and I think we have already begun to see this – Doug, you made mention of this in your comments – it’s a positive sign that we’re seeing both safe haven buying in treasuries and bunds and gold.  A lot of the buying that we have seen in here, regardless of what is coming, inflationary or deflationary outcomes, is just asset preservation-oriented, liquidity preservation-oriented.  And I think gold will continue to see that kind of safe haven buying, as it is reliable.  

The last part of the question – various asset prices worse compared to gold?  I guess my assumption is that if we continue to see an inflationary trend you may have stock prices rising.  The Dow-gold ratio at roughly 10-to-1, I would still be a better on gold at this point.  I would be very comfortable looking at the Dow-gold ratio at 20-to-1, expecting a contraction closer to 10 before we get to a classical 5-6, and maybe even the outside shot at a 3, 2, or a 1-to-1 ratio.  So again, we’re talking relative, and I think gold has a place in play over the next 3-5 years. 

Doug, the next question for you:

Since interest rates are being reduced and yields are next to nothing, wouldn’t money flow out of bonds, treasuries and CDs and go into stocks where you have a chance to get some kind of a yield, or some kind of a return?

Doug:  I’m expecting a global de-risking, de-leveraging event, and as I discussed earlier, I believe there has been unprecedented leverage speculation on a global basis over recent years.  This leverage has created the perception of globalized liquidity abundance, loose financial conditions.  But a reversal in this speculative leverage – that will destroy liquidity and tighten financial conditions.  I believe risk off, when that backdrop unfolds, that would see huge outflows from equities, especially from the ETF complex.  I would also expect a tightening of credit conditions to see a sharp pullback to stock buy-backs.  And I appreciate that it appears today that liquidity is poised to flow freely into equities and markets, basically, forever.  But I believe the liquidity backdrop is much more tenuous.  And again, we saw a hint of this just in December.  The transition from risk-on to risk-off creates extraordinary return opportunities on the short side, so our focus is following speculative trading dynamics in trying to catch a change in financial conditions.  

David:  Doug, this next one deals with the contrast between fundamental analysis and technical charting.  This person asks:

First time listening in.  Just want to see what transpires during these presentations.  What degree do you use fundamentals versus technical charting?

Doug:  Thanks for the question, and thanks for getting on today’s call.  We’re fundamentalists with a focus on top-down and bottom-up, just fundamental analysis.  But we very much respect technical analysis.  We look at a ton of charts when we do our analysis.  We actually use an outside technical analyst for the team to complement our fundamental work.  Technical analysis has always been especially valuable to me on the short side for risk management purposes.  It is a good discipline to follow and discuss the technical backdrop when setting position target sizes.  And also, it is critical for imposing risk control, so I’ve always said throughout my career, ignore technical analysis at your own peril.  

David:  The next question is:

How do the negative interest rate policies impact credit-related products?  What would the U.S. Treasury or Fed do to account for repricing of credit?

Doug:  Negative rates, and even low rates generally, have a huge impact on credit – credit pricing, credit allocation, issuance, and credit conditions generally.  We have witnessed dramatically of late, low market yields spur an indiscriminate chase for higher yields and risky credit products, and this feeds an expansion of uneconomic businesses and classic ostrich-school mal-investment.  We are seeing all of this, and we have in recent years, and if this type of credit cycle is allowed to continue for too long in the cycle – we’ve witnessed this cycle go on, it seems like, for eternity, at least a deep structural maladjustment – and this type of system becomes increasingly vulnerable to any tightening of financial conditions.  I think this is the case not only in the U.S. but globally.  

And the second part of the question, I’m not quite clear as far as whether the repricing you are referring to is on the upside or the downside, but as we are witnessing currently, the Fed is ready to push through with added monetary stimulus to extend the life of this cycle, to forestall any repricing of credit as fundamental prospects deteriorate.  I think that has been the goal of the dovish U-turn since January.  But extending late cycle excess, what I refer to as this terminal phase, is really, really dangerous policy and a lot of systemic damage can be done late in a cycle, and this law will be more obvious later on when credit slows.  

David:  This next one is an economic question:

Home building and construction in general seem to be a pivotal aspect of the global economy.  I worry that there is no plan beyond continually building more and I don’t that is possible due to limited resources and overcrowding.  At this point in the global construction boom, we seem poised for an inevitable downturn.  Aside from agenda 23, what plan is there to transition the economy to something sustainable? 

Doug:  I’m not sure in this context what sustainable refers to.  We’re building plenty of housing units here in the U.S.  China is said to have 50 million vacant apartments.  So I would tend to think that for the future we’re building the wrong kind of housing, and there will have to be a shift as the cycle turns.  But as far of any type of plan, I certainly haven’t heard of anything, David.  Maybe you have.

David:  I think I’m probably not as concerned with a Malthusian limitation of resources and overcrowding as much as I am certain limits.  If you don’t have an increase in income there are limits in terms of the cash flow that people can set aside for a first-time home purchase, or a regular mortgage payments.  So the pricing aspects, whether it is here in Colorado, or as we visit clients throughout the country, we find the unaffordability to be a real factor.  And no, there is not building being done in low income housing.  It is just not the sweet spot.  It’s not where money is being made by builders, which means probably in the long run we end up with an overhang of supply.  And you mentioned, Doug, (laughs) that there may be a little bit of over-supply if 50 million apartments is an indication of overhang. 

The next question is, and it sounds like there is a little bit of frustration in this question:

How long before the capital is destroyed in this lunatic race to the bottom and beyond.  How long before NMT and universal basic income rule the roost to absolute disconnect with reality, and is this economic environment becoming more like Disneyland?

Doug:  (laughs) Disneyland is a too-pleasant way to describe this.  Yes, this has just turned crazy.  The markets are dysfunctional.  Policy-making is catering to dysfunctional markets.  It is just hard not to be concerned that this late cycle is creating issues that we are going to have to deal with financially and economically for decades to come.  But I just hope things are not as dire as I fear they are.  

David:  Obviously, our theme today is about yields and this question is:

If global bond yields are prevented from being at a natural level and they are being through price discovery, normal supply and demand, we have this extraordinary third party artificial buyer, if you will, will the pressure be released there through declining currencies? 

I guess this is a question of how much debt can we purchase, how much expansion of Fed balance sheets or other central bank balance sheets – I’m elaborating and adding a little bit to this question for you, Doug – how much can that be done before people scratch their heads and say, “Is this too much, and should there be a discount applied to a particular currency – yen, euro, dollar, what have you?”

Doug:  In the old days you would expect the currency markets to discipline governments and central banks, but currencies are relative, and governments and central banks all seem to be following the same policy, so it is a case of a group of very impaired currencies trading against each other.  

David:  Does that to some degree mask what is happening?  If you are all kind of moving down on an escalator, three of you together next to each other, you don’t really realize movement.  There is nothing to contrast it with.  Everybody is moving in the same direction at the same time – there’s not drama.  Wouldn’t you have to look to – it almost seems like – when I see a Jeff Koons, current modern living artist, when I see a sculpture sell for $91 million dollars (inaudible) _01:18:15_, or I see haystacks sell for 110 million dollars, (inaudible) _01:18:23_ to me it seems there is some smart money who are already getting the picture that we have a decline in currencies and they just want to own something real.  So real assets, real goods, end up showing what is masked in this relative currency game.  

Doug:  That’s a good point, and the prices paid for art, or Manhattan penthouses, it’s incredible, and a lot of it, these are hedge fund players, billionaires, that I think they would prefer just selling financial assets, rotating out of financial assets.  They are not concerned as far as how much they pay for these hard assets, they just want out of financial assets, and I can’t blame them for that.  

I was just going to throw out also that the fact that these currencies are all relatively weak together and that central banks all seem to have an open-ended ability to create liquidity, open-ended QE, then that creates this view that interest rates can go to zero, markets yields can go to zero, and they can stay at zero forever.  And that perception has allowed Washington, and governments all over the world, to have enormous deficits and for credit systems and financial systems to create a lot of really suspect financial claims.  

And I just don’t think that you can continue indefinitely to create trillions and trillions, tens of trillions, of fundamentally suspect financial claims without a comeuppance at some point in the marketplace, and that would be a spike in yields, some type of crisis of confidence in bonds.  I know it sounds ridiculous today with yields where they are, but I think this is an aberration and at some point market discipline will return, especially in the debt markets.  I wouldn’t get used to negative yields forever.  

David:  (laughs) And this next question, I think, ties in:

What indicators should we look for to tell us that the global debt crisis has become unmanageable – sovereign debt, corporate debt, student debt, CLOs, credit card debt?  Why have interest rates not risen with all of the debt around the world?

Doug:  Yes, exactly.  I refer to the global government finance bubble.  It was unleashed during post-mortgage finance bubble reflationary measures.  As I discussed earlier, the analytical focus must be global as opposed to indicators that were helpful in analyzing the mortgage finance bubble.  Back then my focus was the periphery of mortgage credit – subprime and derivatives, etc.  My focus right now, looking globally, is China as a potential catalyst, so I will continue to closely monitor developments in China money markets, corporate credit lending, China repo rates, credit spreads.  

And I want to focus on the periphery because that is where we initially see the risk aversion, the tightening of credit.  Last year, issues in EM and currencies provided early signals for the instability that hit core U.S. markets later in the year in November and December.  So I will closely monitor EM credit conditions and currencies.  Also, the European periphery can provide important clues to loosening or tightening of global financial conditions and the probabilities for risk-on or risk-off speculative dynamics.  The hedge funds are big operators in European debt markets so we have to focus there – global junk bond spreads, monitoring spreads wherever the hedge funds are leveraged.  

And as I mentioned earlier I will be watching carefully for a tightening in repo finance in China and potential contagion effects to start impacting repo markets elsewhere.  Asian debt markets should be monitored very closely, for example.  I will also follow Asian sovereign debt spreads, Asian bank CDS and stock prices also, of course.  Because that region has been a huge egregious borrower, and those credit systems have inflated tremendously with resulting vulnerabilities.  

David:  A couple of things come to mind from what you mentioned earlier, Doug, because I think one of the indicators that we have, coming back to this question, is from Powell, himself.  When he starts saying that he is focusing on global risks in his talks these days, what are we talking about exactly, because this is domestic monetary policy with two explicit mandates of full employment price stability.  So the fact that we are now considering global risks, and that is the impetus to lower by 25 basis points, or 50 basis points, whatever it may end of being at the end of the month, that is somewhat showing his hand, just as we saw, I think, a very critical communication to the markets December 26th to January 4th when all of a sudden Powell is responding to this market decline in equities and he has been all four raising rates and now all of a sudden he has an about-face.  

Something is happening within the structure of the financial markets that he is watching, and he is not comfortable with it, at all.  And so much so that he is willing to turn and do a 180 in terms where he thinks policy should go from that point forward.  So what you suggested earlier is, I think, critical.  What is he looking at now which represents the “global risks” that are sufficient for him to redesign monetary policy strictly from a domestic orientation to an international orientation?  Is it global securities finance, is it global derivatives, is it the global repo markets, as you were suggesting, with China?  To some degree, if you are looking for indicators, they may already be there. 

Next question, about demographics: 

What does demographics have to do with our investment decisions?

Doug:  David, do you want to take that one?

David:  (laughs)

Doug:  Not too much with our investment decisions.  It’s a little bit of a top-down but I don’t see a big role in demographics as far as how we look at different markets or investment trends.  

David:  I think I agree with that.  We’re looking at slightly different variables.  Certainly that factors in on the risk side, but I don’t think it directly impacts our investment decision as we’re lining out either Tactical Short or the MAPS strategies (inaudible) _01:25:49_.  So maybe I don’t have a perfect answer for that. 

The next question is:

I have very little equities (inaudible) _01:26:06_ globally, so what’s the big deal?  I would like more info on shorting stocks as I have only done puts, and in leaps, so these are a longer term put strategy. 

I guess to summarize the question, Doug, if we don’t have a global equity exposure and U.S. stocks are out-performing, is there any reason for concern.  Let me translate the question a little bit differently.  Aren’t we a higher quality financial market with ultimately lower downside to begin with?

Doug:  We’ve had our share of excesses.  I certainly believe that vulnerabilities here in the U.S. are not recognized whatsoever.  The links between the U.S. securities markets and some of these global fragilities are not understood.  So I think there is a lot more risk here.  And again, we saw a hint of it in December.  I think regarding the question also, I think he is asking for more information on shorting stocks, so I’m going to throw out my long-held view that individual investors should be dissuaded from shorting stocks.  Especially in the current environment, the risk is high and risk management challenge for individual investors out their own, shorting stocks is a risky proposition, so I would proceed cautiously if that is what you are thinking about doing.

David:  Well, and in support of that, let’s go back to our Q1 comments where you spent some time discussing the Goldman-Sachs most short index.  These would be individual companies where investors are just saying, “It can’t possibly go any farther, and yet, there in the first quarter, guess who is getting absolutely slaughtered?  The stocks that couldn’t possibly go any farther were out-performing on the upside.  So the losses accrued for anyone shorting those individual positions were even greater.  So I would tend to agree with you, there is a harrowing amount of risk there.  

The next question is:

The silver-to-gold ratio at historic highs, what is your recommendation on which to add to my portfolio?  Would you recommend converting platinum or palladium into silver or gold at this time?

I think this one is for me, Doug, a little more metals-centric.  The silver-gold ratio hit a peak of 93 and change less than ten days ago and has slipped below 90 in the last 24 hours.  It has been interesting to see silver begin to catch up.  I think one of the concerns that I have had about this move in gold over the last six weeks is that silver hasn’t followed.  In fact, the ratio has gotten larger and larger, indicating on a relative basis that silver is pretty weak.  Now it is playing catch-up.  I would like to see it move a little bit more because even in the upper 80s that is still in the nosebleed section.  

What does it say from an investment (inaudible) _01:29:29_ point?  It says that if we do have follow-through on the gold price, and silver continues to follow, that ratio should settle in somewhere around 40-to-1.  40-to-1 versus 90-to-1, you’re looking at things from a performance standpoint.  Silver outperforms gold 2-to-1 from these levels.  Obviously, there are some assumptions in there about the continuation of gold and the follow-through of silver, but I think that is pretty reasonable.  If you look at the top end of the range, the gold-silver ratio has always topped around 100, and on the low end has been about 15.  Your average through the last 100 years is around 30-to-1, and a normal trading range for a trader to play the ratio is somewhere between 40 and 60.  So silver at (inaudible) _01:30:15_ 60 sees lots of action, we’re above that 60 level, meaning that silver is really as cheap as dirt.  

I think I would say one other thing.  I would not be converting platinum or palladium.  I tend to see these metals as separate trades where the metals trade you might consider in the platinum group is in the direction of platinum – out of palladium (inaudible) _01:30:44_ and I have a hard time reducing gold exposure to go into silver just because of the incredible risks within the financial markets and I think gold is a very reliable insurance-type product.  If you already have a position in the metals and are adding, then there, you just pick the value.  Then the value is silver.  The value is platinum.  Those are the two easiest values to pick up. 

Next question, for you, Doug:

Your thoughts on using shorter-dated put options on the S&P to add portfolio protection from a left tail market event.  As you know, Elliott Wave Analysis may be interpreted to be a new high in U.S. equities in the coming months and the first major low to occur in a time range of 2021 to 2023.  Any thoughts on that?

Doug:  Yes.  I tend to not like using short-term put options.  As an analyst of the top-down, a lot of times these things take longer to materialize than one would expect.  Early on in my career I missed a couple of major moves by a month on my options.  So I developed more of a preference for getting some time with my options.   What I will do is, if I start to see something develop on the periphery that I think could provide an opportunity I might go out and buy an option with a four-month, five-month, maybe even six or eight-month maturity.  

Then I also tend to sell them with a month to go, or to roll them out and replace it with a put with a longer maturity.  There are a lot of games.  These puts – they work great in theory – limited risk, potential big upside.  But in practice, they are very, very challenging.  And again, I’ve traded them for over 25 years.  I don’t like holding puts, especially with much value, going into expiration because there are a lot of games that are played.  So my preference, generally, with puts is instead of trying to hit home runs, try to hit singles, doubles, maybe the occasional triple.  And that means sometimes taking money off the table and selling your puts before expiration even though you think that they might be worth more at expiration.  

David:  The next two questions I’m going to merge, and then actually push off into the future.  

One is to comment on gold and gold stocks, in particular.  And what is your stance regarding commodity-related equities, especially in the agriculture sector?  

I’m going to combine those because while we are very interested in real assets it is not so much the Tactical Short which has that as a focus.  Our other strategies, the Multiplier, Accumulator, Protector and Strategic – those four different market strategies with invested (inaudible) _01:34:11_ assets are interested in hard assets and a variety of assets from infrastructure to global natural resources, and yes, even precious metals, mining shares, and things like that.  

But let me suggest this.  If that is an area of interest, join us for our third-quarter call.  It will be our first initiated call like this.  Tactical Short has been doing this now for several years.  We will have that initiated for the third quarter, and I will present some ideas as well as my colleague, Lila Murphy, and we will dig into the deep end, if you will, to kind of look at the whole hard asset spectrum (inaudible) _01:34:53_ and give you a better idea of perhaps what we are thinking there and how we are approaching that.  But again, I think that is probably better context for the MAPS strategies, as opposed to Tactical Short, because frankly, they don’t get included into a Tactical Short strategy.  

Well, we have most of the questions responded to and I’m just going to double check and make sure that the ones online have been adequately addressed.  In fact, let’s do this one for you, Doug, just to end.  This is from Richard.  I would like to see what your response is because I already responded to him online.  

With likely aggressive central bank intervention through more QE, what will you do if asset prices rise in nominal terms and losses are taken in the currency?

Doug:  It is simple for us.  If we’re losing money we get more defensive.  If we saw some really strange market dislocation on the upside from QE, we can get completely out of the market.  We can go to zero.  There is also a scenario where I would completely unwind our short exposure, our short positions, and replace that with some put trading, and play it with puts, expecting wild volatility.  So there are different ways we can play this. 

I just want to throw out that I think the misconception on QE is that, even thinking back to 2008, the first trillion dollars of QE in 2008 here in the U.S. basically just went to accommodate de-risking, de-leveraging.  It was not new liquidity in the system.  It basically just transferred leveraged positions from different financial institutions and hedge funds, etc., to the Fed’s balance sheet.  So I think we could, in a de-risking, de-leveraging environment, a serious risk off, we could see trillions of dollars of QE go to just accommodating de-risking, de-leveraging, without adding any incremental liquidity in the markets.  So that could be a real negative surprise if central banks start employing aggressive QE if the markets don’t seem any more liquid.  And that could be part of the unfolding crisis of confidence in policy-making.  But we’ll just have to follow developments closely and see how this plays out.  

David:  Well, Q3 (inaudible) _01:37:31_ may be a very interesting environment for us.  Doug, as you have laid out today, this is an amazing environment from an analytical framework, a fascinating time to be managing assets, and particularly on the short side there are things that have never been done before, never been seen in the U.S. financial markets.  

So we are grateful to be partnered with you, we look forward to answering any questions that you may have.  If you would like to get in touch and visit with our team about he can partner with you, either to run alongside     portfolio, or for this to be something more of a speculative, we would like to explore how we can be of service to you.  

So on behalf of McAlvany Wealth Management and on behalf of the whole team, I want to thank you for joining us on the call today and partnering with us, for those of you who are already existing clients. 

Doug:  Thanks a lot everyone.  Good luck out there.