David:  I want to welcome you to the McAlvany Wealth Management Tactical Short Conference Call here April 19, 2018.  We are, this year, celebrating our 46thyear of operations, the 10thyear for the Wealth Management Group as it is currently configured, and we just passed our first full year anniversary of managing the Tactical Short and so we have a lot of exciting things to share with you, not only in terms of what this last year has looked like, but also what we anticipate in the coming months.

If you care to mark your calendar as an existing Wealth Management client, our client conference here in Durango, Colorado is September 13ththrough the 15th.  As many of you now, we make an effort to go see you as often as we can, and usually late summer, early fall, is when we invite you, if you would like to meet with your team, sit down with everyone, and not only share meals, but great conversations, and of course, the briefings from all of our assets managers.  So if you are an existing Wealth Management Client, that invitation is open to you.  Mark your calendar.  We look forward to seeing you.

Just by way of anticipating the next quarterly conference call for the Tactical Short we will have the same chat functions as we have here today, and as we move to the Q&A we will be looking at not only the questions that you have submitted ahead of time, but if something comes up that you feel is pressing, I will be checking in on that chat function as well, to be able to add those to the list.  If for some reason we run out of time please flag those questions and come back in a personal conversation and address those with you.

But also for next quarter, Doug and I would like to include some charts, so there will be some online functionality, which will allow you to see some of what we are sharing in terms of just raw data and statistics.  So rather than trying to take copious notes, bear in mind this is a recorded conference call so you can go back and listen to it and there will be transcripts.  But if you like the charts, as well, that will be in the next iteration for the next conference call.

We have titled this conference call “Market Structure, Trump Tariffs, and Higher Rates:  Markets at a Precipice.”  I want to introduce a couple of his ideas and then I will pass the baton to my colleague, Doug, and he will cover where we are with the Tactical Short, and where we are going, as well.

In terms of the market structure, what we have seen here in the last two to three months since our last conference call is not only a significant amount of volatility, returning to the market after several years of a virtually deadened market where the pulse was barely available to be taken for any of the major indexes.  Looking at the volatility index, it basically went to sleep. Very typical, of course, is when the VIX gets to record lows, that is when everyone assumes that all is well, and sometimes when everyone assumes that all is well something goes haywire. We had that late in January and early February with the market selling off.

Since then we have had a series of failed rally attempts, and I think this is very critical to hone in on in terms of market structure, because essentially what those failed rally attempts communicate is that institutional investors are testing for a top.  They want to see if they push prices up a little bit if there is going to be some momentum return and if there is going to be a resumption of the uptrend in the equities market.  And so far, each of those rally attempts has, in fact, failed. So we had the primary peak in January.  The secondary peak at a lower level in March, which again speaks to the energy or lack thereof in the equity markets today, not picking on any particular index here, but actually true of all of them.

And very telling if you are looking at all of these indexes is that the majority of these rallies have been on weak volume. So ordinarily you would want to see a robust return, a robust resumption of an uptrend, with the audience for equities growing with greater enthusiasm and I think the operative word here is tepid.  The majority of the rallies have been on weak volume and very telling in terms of distribution trends is that each of the sell-offs has been on increased volume, again, which would suggest that we are in distribution phase, and while we have been testing for a top, there are enough people who are actually getting out of the markets, and using each rally as a means of moving to the sidelines.

In January it was interesting, we had, of course, the peak in ETF purchases and public buying of the major indexes, what we would call capitulation buying, folks who had been on the sidelines and they just couldn’t take it anymore.  They had to get in the stock market, they had to own something, the American Dream, the uptrend.  Everybody seemed to be making money, and so there we had a last made dash into equities, and we saw that in very dramatic fashion, if you are looking at the funds that were coming into the exchange-traded funds in particular. Your low cost ETFs were just blowing up, record numbers on a weekly, monthly, and quarterly basis.

A few things to look at, again, all in the category of market structure.  Here in recent days and weeks we are seeing the divergence between financials and one sector, of course, within the S&P 500.  That divergence is a negative divergence.  The financials are moving lower while the S&P 500 has been holding its own or moving higher.  It used to be said that the financials led the market, either on the upside or the downside.  Just keep an eye on that divergence and see if it continues to widen.  If there is a yawning difference between the two, then odds are the markets fall lower, and that is interesting because I think it coincides with a seasonal bias which is coming to a close here.

We have options expiration this Friday and with that behind us, and the good six months out of the year behind us as well, where you typically see funds come in for retirement assets, 401ks, IRAs, the funding which is, classically, November through mid-April, the tax season. The good six months are behind us. So, a number of things for us to consider in terms of market structure, and Doug will, of course, expand on that, as well.

In the category of Trump tariffs, we’re fascinated.  We’re fascinated to see the U.S. press for some advantages, and they have gained some advantages. We will talk in detail about that in a little while but you have Germany, and you have Europe as a whole, along with China, which are stalling economically, and you see the PBOC, the People’s Bank of China, and the ECB, are again trying to gin up the financial system, this week the PBOC lowering the reserve requirements for banks, the ECB going back into balance sheet expansion mode.

The ECB balance sheet, they’re monetizing that again and as of this week they hit a new fresh high, 4.548 trillion euros.  Again, there are some issues as it relates to the tariffs but it’s with a backdrop of growing concern economically.  The U.S. economy, we’re getting some decent statistics.  You could pick on some areas of weakness in retail and in housing, but you could offset those with some positive statistics, as well.  Doug has long made the case that there is a difference between the economy and the financial system and we are seeing cracks within the financial system.

So the tariffs, again, this is an opportunity for Trump to press and advantage when our global trade partners are somewhat constrained.  There is not a lot that they can do, the bigger picture, if you have read some of Doug’s comments in recent weeks in the Credit Bubble Bulletin, which I would encourage you to read routinely on a Friday evening, Saturday morning drumbeat.  The Trump tariffs, and the tariffs in general, are a part of geopolitical deterioration.  This is, I think, the bigger issue.

If you are looking at global e-commerce, China is taking on a larger and larger role.  Ten years ago they were 1% of global e-commerce.  Today, according to the world economic forum they are 42%.  The U.S. was 35% of global e-commerce.  We are now 24%.  In terms of a breakdown of global GDP, if you look at the entire Asian block, including India, China, the entire Asian block is 33.8% of global GDP, North America is 27.9%, Europe 21%.  And PriceWaterhouseCooper suggests that over the next 20-30 years this is going to be revolutionary with China becoming number one, India becoming number two, and the U.S. becoming #3.

I don’t know that I fully agree with PriceWaterhouseCooper on some of the finer points of their argument.  But what is at stake here is a global leadership role. So when you look at the trade tariffs this is one part of a bigger issue, and it is U.S. hegemony, and it is the role that we have played as the world’s reserve currency.  These are the things that are in play with the big question being who will lead in the 21stcentury?

The last part of our title today is higher rates. This is where you look at the total stock of debt and recognize that higher rates is one area where if you can control the rate of interest, you can continue to expand the debt. Alternatively, if you can grow your economies, that economic boost and the growth from that activity can go a long way toward supporting greater amounts of debt.  I would argue that the scales are little bit off here, and that with any increase in interest rates we have room for destabilization within the bond market and the whole financial markets as a whole.

Go back ten years, one decade ago; we had very different debt figures.  We entered into the global financial crisis roughly ten years ago, and it was a financial issue with there being too much debt and too much creative finance in the system.  Total debts globally today are 237 trillion.  That is 70 trillion more than we had a decade ago.  For the 70 trillion in additional debt that we have globally, we have gained 21 trillion in global GDP.  So again, just rolling back the clock, we were at 63 trillion in global GDP, now we’re at 84, that is the estimate for 2018, and debt, again, we’ve added 70 trillion to that.

Again, dollar-for-dollar match-ups, we had that in the 1970s and 1980s we began to see some inefficiency in terms of more debt and less economic growth generated by that debt, and it has become more inefficient as time has gone on.  The U.S. is at $2.10 in new debt for every dollar in economic growth. That has been the case over the last ten years, so we’ve added five trillion to GDP, we have added 10-½ trillion to our national debt.  That is just U.S. government debt, not talking about the rest of the mix, 65 trillion in that U.S. pot.  But where it is really confounding is globally, $3.33 in debt for every dollar increase in GDP.

What it really suggests is that we have a battle ahead.  We thought we had a battle and that was somewhat behind us, getting rates to the zero bound. And now we have the talk of normalization.  Now we have balance sheets which are going to be shrinking, except the ECB which I mentioned just a moment ago is not shrinking, it is back to expanding.  But we are on a schedule here in the U.S. to shrink our balance sheet.

What does that mean?  That means we are taking assets that are on the balance sheet, we’re bringing them back into the market on the assumption that there is a hunger for those assets, that they are going to be absorbed.  The challenge is that we are running larger and larger budget deficits at the same time.  The bottom line is, at least for the U.S., it implies that we are going to have to find people to fund an extra 1 to 1½ trillion dollars in government debt this year, and that is possible, but we will see how that is reflected in the interest rate environment.

This is a bit of an introduction to those three things – market structure, the tariffs, and higher rates, and some of their implications.  Again, we are dealing with a mountain of debt, and now with interest rates beginning to creep up here in the U.S. and around the world you have to ask the question, what are the implications into the financial markets with there being multiples of debt even from what we had in the global financial crisis circa 2008 and 2009.

I want to hand things over to Doug and he can take us a little further into the Tactical Short, how we are structured.  And then once he is done with his comments – and I might interject something, too, a little bit more on the geopolitical here in a few minutes – then we will transition to Q&A and spend the rest of our time in Q&A.

Doug:  Thank you, David. Good afternoon, everyone. Thank you for taking the time to jump on today’s call.  As always, special thanks to our account holders.  We hold dearly the relationships we are developing. For new listeners that may be unfamiliar with Tactical Short we have detailed information available at mwealth.wpengine.com/tactical short.

Let me begin with a brief overview.  The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in the client’s total investment portfolio while providing downside protection in a global market backdrop with extraordinary uncertainty and escalating risk. This strategy is designed for separately managed accounts or SMA.  We will short securities, stocks, ETFs.  We will also, on occasion, buy liquid listed put options.  We continually gauge risk versus reward on each individual position.  Shorting entails unique risks.  Our job is to remain keenly focused on managing risk.  This sets us apart from others.

We tactically adjust our short exposure. We expect to generally target exposure between 50% and 100% short.  Our maximum short exposure in 2017 was 36%.  Exposure was at 18% at the time of our January 18thconference call.  Currently, short exposure is targeted at 60% and I will have more on exposure in a few minutes. We see Tactical Short as an integral component, let’s say a 5-20% allocation within a well-diversified investment portfolio.  We don’t recommend big bearish bets against the stock market and instead believe it is time to refocus attention on risk and disciplined risk management.

We expect to see environments where we will be opportunistic, seeking outsized returns, but generally, the strategy will endeavor to have less volatility, a lower portfolio beta in the U.S. equities market.  My career managing short exposure dates back to 1990 – I’m feeling pretty old these days. Tactical Short is a unique offering in the marketplace.  We’re convinced we have structured a better mousetrap when compared against other hedging products.

We structured Tactical Short differently. We wanted to ensure flexibility to navigate through even the most difficult market conditions.  I will repeat what I have stressed in previous calls.  Remaining 100% short all the time, as most products are structured, is risk indifference. Risk indifference on the short side doesn’t work.  These products adjust short exposure based on changing risks and opportunities.  We know it is imperative to do so.

I will update performance.  Tactical Short accounts after fees gained 0.24% during the 1stquarter.  The S&P 500 returned -0.476%.  The strategy now has one-year performance numbers.  From our April 7thinception date through April 6, 2017 Tactical Short returned a -2.74% versus the S&P 500 that returned a +12.62%. We regularly track our performance versus three actively managed short fund competitors.

The Grizzly Short Fund lost 1.39% during the 1stquarter and they have a one-year number ending April 6ththat a loss is 13.25%.  Ranger Equity Bear made 5.36% the 1stquarter.  Their comparable one-year number is a loss of 7.25%. Federated Prudent Bear Fund gained 0.32% during Q1.  Their comparable one-year number is a loss of 10.88%.  The benchmark performance versus the inverse of the S&P 500 in our first year of operation, Tactical Short’s 2.74% decline was about 22% of the inverse of the S&P 500’s return, significantly outperforming our competitors.  I’m not overjoyed with performance, but we have navigated satisfactorily through a quite challenging period.

Let’s take a deeper dive into 2018’s 1stquarter, a remarkable period in many respects.  The S&P 300 returned 7.55% through January 26th, an all-time high.  After ending February 1stat 2822, the S&P 500 abruptly traded down 10% to an inter-day low of 2533 just six sessions later on February 9th.  From that trading low the S&P 500 then rallied 10% to trade within 3% of all-time highs in mid-March.  NASDAQ posted all-time highs on March 13th, (inaudible) 21:41 returned into quarter end.  Candidly, this is the type of market volatility I dread the most.  Wild volatility creates challenges for managing the Tactical Short strategy. In a strong market backdrop we can hunker down and focus on wealth preservation.  If it is a weaker market environment we will build short exposure and be more opportunistic, but going from melt-up to the brink of melt-down in about a week’s time presents quite a management challenge.

Speculative market dynamics through much of January dictated a focus on risk management and capital preservation.  During January’s conference call we were asked why short exposure was not at zero, and I’m sure some are questioning why we weren’t better able to capitalize on an abrupt 10% market decline.  I believe strongly in our risk-focused strategy and my first priority is to avoid outsized losses.  Tactical Short began the year with targeted short exposure at 22%.  Short exposure was down to 16% by January 21st.  We reversed course and began building short exposure the following week, and we were up to 24% by the time of the February 5thmarket downdraft.

The bottom line is we had limited time to boost short exposure.  I subscribe to a disciplined investment process where we add exposure incrementally when we see confirmation of our fundamental thesis.  We are not in the business of placing big bets on short-term market direction.

I’m a long-time bike-rider and over the years I have made analogies between biking and managing short exposure.  There are disciplines:  Keep firmly ahold of the handlebars.  Your head stays up.  Remain steady and alert.  And definitely avoid abrupt movements, that is, unless you find yourself in harm’s way.  If a truck is suddenly coming right at you, you will take your chances and put you and your bike down in a ditch.  It is always the most fun flying down hills, but you risk losing control. You sacrifice flexibility, just as risk is expanding exponentially.

The key is maintaining a disciplined focus on identifying possible hazards, and the faster you travel, the more difficult it becomes to recognize approaching risks.  Granted, it may not be as fun and as exciting, but you can have a rewarding long ride if you avoid crashing and burning.  My goal is to ride my bike and manage short exposure.  Hopefully, for some of you, when I’m 75 I’m done flying down hills.

But back to the extraordinary 1stquarter, we ended March at 52% short.  I will discuss a few of the key market developments during the quarter. First there was the blowup of the so-called short ball strategy, a major development from the standpoint of my analytical perspective.  Almost a decade of unprecedented central bank monetary stimulus and market support created the perception that security prices only go up and there has been no surer way to generate strong returns than by writing various forms of market protection, selling flood insurance during the drought.

The Credit Bubble Bulletin begins each year with a focus on key issues for the upcoming year.  I titled this year’s piece, “Issues 2018: Market Structure.”  Serious, and I would argue, epic market structural shortcomings have accumulated over this prolonged period of ultra-loose financial conditions and associated market excess.  There has been a proliferation of sophisticated derivative strategies that are variations of selling market protection.  There is a 4+ trillion ETF complex which is essentially a bullish bet on market direction that is untested through a complete market cycle.

There is also the 3+ trillion dollar hedge fund industry that has crowded into risk-on strategies, incorporating aggressive risk-taking, and as always, leveraging.  During the eruption of extreme market instability markets experienced extraordinarily high correlations across asset classes and across international markets.  This was important confirmation of the unparalleled nature of synchronized securities bubbles.  This extraordinary global backdrop, a proliferation of derivatives, crowded trend-following trading, leveraging, and all the rampant speculation points to unprecedented market liquidity, vulnerability and latent fragilities.  Some of these latent risks started bubbling to the surface during the 1stquarter.

I have drawn parallels between a February blowup and the short volatility funds and the collapse of the Bear Stearns structured credit funds back in the early summer of 2007.  This amounted to the initial crack in the mortgage finance bubble.  The subprime eruption proved the beginning of the end.  It was a historic inflection point for risk-taking, leveraging and marketplace liquidity.  Recall, however, that it took about 15 months of unstable markets to evolve into a full-fledge financial crisis.

During the 1stquarter we saw the arrival of a new Federal Reserve Chairman, Jerome Powell.  He is not an academic.  He is not wedded to arcane theory, rigid economic doctrine, or dubious econometric models.  I even suspect he is not an inflationist.  Powell has been skeptical of the benefits of QE and appreciates the risks associated with activist policy-making.  I believe Chairman Powell will direct a regimen change at the Fed.  The FOMC will show more determination in pursuing policy normalization, readily backing away from experimental policy-making.  Our central bank will be less eager to coddle the stock market.

Going forward, the Powell Fed will be cautious in redeploying QE.  This implies risk, less certainty with respect to the so-called Greenspan, Ben Bernanke, then Yellen market put, that has underpinned markets for three decades.  CPI ended the quarter at 2.4% year-over-year with core CPI up 2.1%.  Even FOMC doves are now calling for gradual rate hikes.  Ten-year treasury yields have jumped 50 basis points so far this year.  They closed today 2.91%, getting close to that 3% hurdle.  Two-year yields were up 56 basis point year-to-date.

The 1stquarter witnessed a noticeable dimming of the treasury market safe haven status.  In general, fixed income registered losses for the quarter, junk bonds suffered large outflows at times and even investment grade credit showed vulnerability to destabilizing ETF outflows.  So-called risk parity and other sophisticated strategies, many incorporating leverage, showed vulnerability in the shifting market landscape.  David, I’ll send it back to you.

David:  Again, we titled this call “Market Structure, Trump Tariffs, Higher Rates:  Markets at a Precipice?”  And of course, we have a question mark there.   But when you look at market structure, what was exposed here in the 1stquarter are a number of serious issues, and I think one of the things we have got to recall is how quickly market liquidity vanished.  It is there in abundance and everyone assumes it is there, and then literally vanished overnight.  We had that on display here in the 1stquarter.

In terms of geopolitical risk, that becomes a very pressing issue for global markets, and arguably, we have reached critical juncture during the quarter.  It is important to appreciate that bubbles are, at their core, mechanisms that redistribute and destroy wealth.  And we have witnessed these powerful dynamics and some very dire consequences with the mortgage finance bubble and its aftermath here a decade ago.  We are today in the throes of, arguably, the greatest global bubble in history.  So with that in mind, geopolitical risk becomes a central issue, and a part of our analytical focus and of Doug’s work on a day-to-day basis.

The president’s tariffs and the aggressive approach with protectionism and trade relationships does become a market issue. We had the introduction of the 25% steel and aluminum tariffs.  Of more consequence is the administration launching formal attacks on China’s trade practices.  China is a major issue, and it is an unfolding major issue.  The focus thus far has been on the trade deficits with China.  The China issue goes beyond that.  It goes beyond unfair trade.  There is the theft of intellectual property, there is corporate and military espionage, there is China’s state objective of technological superiority, hacking and cyber warfare, military buildup which is happening.

Just in the last two weeks we had communication jamming devices which were successfully installed in the Spratly Islands, and there in the Taiwan Straits, the largest ever show of naval force, with five live fire military drills, again, there in the Taiwan Straits.  It is an extension of power and influence in the region and ultimately, globally.  We hold the view that China’s forceful pursuit of superpower status is an over-arching issue.  You have President Trump who believes that the U.S. has, over the years, aided and abetted our competitor and China’s ascension of financial, economic and military power, he believes that a tougher stance by the U.S. is long overdue. That is what our president is taking us into, that tougher stance.

So tariffs and trade sanctions are the opening salvo.  There are going to be modest concessions, but the reality is you are dealing with a strongman toe-to-toe with another strongman.  President Xi is not prone to backing down.  So we would expect U.S./Chinese relations to continue to sour.  We have deteriorating relationships with China, along with China’s strategic partner, Russia, and that creates a new Cold War backdrop, with unfolding negative ramifications for international markets and the global economy.

If you recall, the capital flow constraints which were prevalent prior to the early and mid-1990s, capital controls were all too common throughout Europe and around the world, and as you saw capital controls eliminated and the free flow of capital across borders, you began to see the global economy move into overdrive.  You bring back these Cold War backdrop dynamics and all of a sudden there are some flow constraints, and flow constraints are a bit of an issue.

So we are increasingly concerned with China’s aggressive military posture in the South China Sea and with Taiwan.  We expect a more aggressive Putin, and sanctions are biting into the Russian economy.  Last week’s missile attacks in Syria which absolutely had a broader audience.  This was not just about Assad, but the fact that we included B1s in the mix and could have had 40 times the amount of firepower thrown from those heights suggests that we were speaking to Putin, we were speaking to the Chinese, we were speaking to Iran, we were speaking to North Korea – a much, much broader audience.

But we should be aware that a cornered bear is never an animal to tangle with, and in fact, that may be what we are doing with Putin, putting him in an uncomfortable corner.  Trump’s tariffs mark a critical juncture geopolitically.  Doug I want to hand this back to you, but this is an insecure world, now dominated by strongman leadership.  These are headstrong leaders and they are increasingly butting heads.  You have geopolitical storm clouds darkening here in the 1stquarter, and to be quite frank with you, markets have largely ignored or brushed off these geopolitical factors.  My two cents.  Back to you, Doug.

Doug:  Thank you, David. So for the question, are markets at the precipice?  Very serious market structural issues have been illuminated, in derivatives, in hedging strategies, and in marketplace liquidity.  We saw all of that in the 1stquarter. The cost of hedging risk has begun to increase, financial conditions have begun to tighten, market yields are rising, global interbank lending rates have been rising briskly, getting some attention.  Risk premiums have begun to widen across the risk markets globally.  Investment-grade credit is showing vulnerability, had another rough day in the marketplace today.

Looking globally, overall Chinese credit growth has begun to slow which is a major development while their mortgage and consumer bubble excesses continue to worsen.  These tariffs and trade wars are now a real and present risk to the markets.  The Fed has become more determined to actually implement a tightening to monetary policy. Monetary policy has begun the process of normalizing globally.  The ECB will be winding down its QE over the coming months.

Washington politics are in disarray, and the midterms are about six months away.  There are political scenarios that would be very disruptive to the markets and to the entire country.  Even in a boom time environment the social mood is bitter, divided, and anxious.  As David highlighted, geopolitical risk is now escalating rapidly.  So in our view, the risk versus reward calculus for being short has become more favorable, and we have increased short exposure accordingly. The risk of being short remains high, though, so we are carefully managing our short exposure.

As is typical of market tops, the economy appears strong and earnings robust.  Superficially, things do look okay.  They looked much better than okay back in 2007.  The problem is that markets – that is equities and fixed income – have become a historic bubble, and this bubble has been fueled by unprecedented monetary and fiscal stimulus.  The Treasury has just reported that the Federal government posted a 600 billion dollar deficit just in the first half of the fiscal year. Fiscal policy is now completely out of control.  The downturn will see deficits absolutely explode.  Short-term interest rates, along with market yields, remain significantly below what would be appropriate for this late stage of the boom cycle.

I believe risk markets have been in a historic topping process with all the makings for an unfolding bear market.  Tops are never easy.  This one is of a super-cycle variety.  I see overwhelming support for the bubble thesis.  The finance fueling this extraordinary global boom is unsound and highly unstable.  There are fragilities festering just below the surface.  Markets have turned hopelessly speculative, they are short-term focused, and incapable of adjusting for mounting risks.  The year is certainly off to a wild start, instability appears poised to continue in the markets, in Washington and geopolitically.

Markets have experienced their initial bottom in stability.  Typically, it’s the next sell-off that risks turning into a serious issue.  If money comes flying out of ETF, the hedge funds de-risk, de-leverage, and those on the wrong side of derivative trades move to hedge, I question who will step up and provide the necessary liquidity to accommodate such massive selling pressure.  Reiterating our key message, it is time to refocus attention to risk and disciplined risk management. David, I’ll send it back to you for Q&A.

David:  The questions we have – I’ve got a few coming through on the chat function so feel free to keep on sending those, and we’ll get started also with the ones that were submitted ahead of time, the first of which is:

How many dollars do you need to start with the Tactical Short?

For institutions it is a million dollars. For an individual investor it is $100,000.  A slightly different audience in both cases, but as Doug mentioned, we have set up the SMA structure to be able to somewhat customize that to risk mitigation needs within an individual portfolio.  So institutional accounts, one million, individual investor accounts, $100,000.

Let me direct this next one to you, Doug:

In what percentage terms do you see the coming market capitulation taking place?  Could we see a 50% or greater correction based on the current leverage in the system?

Doug:  That’s a good question.  During my career I’ve seen two bubbles burst, both meeting 50% stock market declines.  My view is the current bubble has inflated much beyond the previous two.  I would expect a greater than 50% decline, although this might unfold not as quickly.  It might unfold over several years, perhaps.  Unlike the previous bust episodes, I believe policy response is that the next go-round will be more limited.  Monetary policy is already loose.  We are well on our way to trillion-dollar deficits.

I also suspect that QE will prove much less effective next time.  The bond market, in particular, may be less willing to accommodate all the QE. There is an important dynamic that goes unappreciated these days.  Not only has this bubble expanded across asset classes, and it has gone global, it has also gone to the heart of contemporary money and credit.  It has gone to central bank credit and government debt.

Back in 2009 I began referring to the risk of a global government finance bubble.  Somewhat later I referred to it as the grand-daddy of all bubbles.  This has gone on much longer and become more dangerous than I suspected.  The danger is that a decade of policy excess risks a crisis of confidence at the very foundation of global finance.  You recall, the 2008 crisis was chiefly a crisis of confidence in private sector debt, private sector obligations.

I feel the next crisis will encompass private as well as public sector debt, which would be a much more difficult crisis to manage, definitely more problematic – a more problematic backdrop to initiate another central bank reflation.  With this in mind, I believe the next crisis is huge unappreciated downside, with ultimate market lows, perhaps, some years into the future.

David:  So 50% is a real possibility.  Let me ask the next question:

If the U.S. dollar crashes and the Fed pours more money into the markets, and we go more into a hyper-inflation and it seems, perhaps, that the S&P 500 would go up because the markets are being fed by more and more money, it seems that in that case, short or bear funds could continue to go down, as they have since 2008 as we have witnessed a rise in prices.

Your comments?

Doug:  I would expect any meaningful pickup in inflation to be quite problematic for the bond market and I think there is a lot of leverage in the bond market is vulnerable.  If hyper-inflation does imply an acute crisis of confidence in the dollar which would be extremely destabilizing for the U.S. debt markets, then U.S. equities, as well, the data is troubling. Foreign holders have amassed huge positions in U.S. financial assets and there are major derivative issues, as well.  The world has seen massive inflation over the past ten years, most of it directed at securities and asset markets.

I believe, myself, the bigger near-term risk is a collapse in asset bubbles, rather than a major inflation outbreak. Hyper-inflation could unfold over time in the next post-crash monetary inflation, but I’m hesitant to try to predict too far ahead.  The key for us would be to adjust the level and composition of our short exposure.

When we see major developments start to unfold, we will want to carefully target where we are short.  There will be more enticing short opportunities in a market index, and we will always remain diligent in monitoring and adjusting the policy responses and other macros forces generally.  Hopefully, we will navigate through this much better than bear products have navigated over the last decade.

David:  I’m going to blend three different questions that have just come in from the chat online function:

  1. How do you prioritize hedging strategies in this climate?
  2. Is there anything I can do to hedge my 401k or traditional IRA?
  3. If I cannot, because of the percentages provided, 5-20%, allocate $100,000 to the Tactical Short, again, how do you hedge in this climate?

I’ll take a stab at this, Doug, and if you want to add anything, feel free.  There are very few products that are provided for within a 401k, so you would have to do most of your hedging elsewhere and look at your portfolio on a holistic basis.  Inside of traditional IRAs, the Tactical Short, we can actually manage a comparable strategy inside a traditional or Roth IRA.  It is not exactly like a cash account because there is some functionality which is just not allowed by the IRS within those structures, but we do have a comparable product for traditional IRAs.

Prioritizing hedging strategies in this environment, if that $100,000 minimum is not an option, my encouragement to you is to look at what has been a counter-cyclical hedge through the years.  When stocks are not doing well, precious metals tend to do very well.  And when stocks are doing very well, precious metals tend not to.  So if we are at an inflection point and you wanted to hedge, even by having $5000, or $50,000, or $75,000 of a hedge, you could do that.  I would rather do that than even choose some of our 100% short all the time competitive products.

Doug, any thoughts, or do you want me to move to the next one?

Doug:  Yes, those are good thoughts.  I concur, David. We’ll move to the next question.

David:

What is your view, on that inflation/deflation debate, regarding today’s market?  And is there too much credit or debt in the system for inflation to be a significant threat? 

Doug:  This is a really good question.  It is an important analytical issue, no doubt about that.  I have always argued that the inflation versus deflation debate is too simplistic.  This debate has been going on now for decades, it seems.  I subscribe to the Austrian economics view.  There are all different types of inflation, consumer price inflation just being one of them.  There is asset inflation, over mal-investment, over consumption, trade deficits.  Those are all part of excess monetary inflation.

For many years now, this massive monetary inflation has led to inflation in securities markets, real estate, and the value of private enterprise.  Let’s not forget about the massive investment and manufacturing capacity in China and throughout Asia.  We now have these bubbles globally, many of them in danger of bursting.  So I would argue that the most important issue is not inflation or deflation – at least, today it is not – but these historic bubbles that have inflated.

And going back 30 years, all the way back to the 1987 stock market crash, and too many times since then, we have seen the Fed and central bankers repeatedly adopt aggressive stimulus measures to fight the so-called scourge of deflation.  But this has only ensured bigger and more comprehensive bubbles.  They are kind of fighting a losing battle there.

Back to the question – is there too much debt in the system for inflation to be a threat?  This amount of debt will limit options, no doubt about that, come the next crisis.  There is a risk of a systemic crisis of confidence in all financial assets the way this is unfolding.

David:  A question that is of a practical nature:

Can a resident of Canada participate in the short program, and what concerns are there for international customers, if you accept them?

Unfortunately, Canadians residents, citizens living in Canada, we cannot open accounts for at this time.

Another question relating to the structure of the fund:

What annual fees are there and what percentage do you take of profits if earned?

While we do operate with the flexibility of a hedge fund, we decided that we wanted to structure ourselves in a way that was different than hedge funds and have a very simple fee structure and not participate in the profits earned.  So your normal 2% and 20, which is common in the hedge fund community, 2% for management and 20% of gains, is not how we function at all.  We just decided a simple 1% fee on assets under management is how we would operate, and that represented for us the best way to partner over a long period of time with clients, keeping our incentives aligned with our clients in a way that was, I think, palatable over the long term.

I just want to note that the Tactical Short conference call today will be downloadable, so in a podcast form you will be able to get that, and here in the next three to four days also, you will have transcripts for it.

Doug, next question for you:

What signals will you rely on to determine if a full bear market is under way, and will the short fund use leverage at that point?

Doug:  The term bear market generally refers to a 20% market decline, so it is kind of a technical indicator.  My over-riding focus is always on financial conditions, more specifically would be marketplace liquidity, credit conditions, risk embracement of risk eversion in the markets.  Are speculators increasing leverage or reducing it?  I have a mosaic of indicators I follow diligently.  I view the hedge fund industry as the marginal source of marketplace liquidity.  So is speculative liquidity expanding or contracting?

That is a critical issue from my framework. I generally incorporate periphery and core analysis, expecting to see incipient signs of tightening of financial conditions at the periphery, and that is, for example, in junk bonds, the emerging markets, small cap stocks.  Once I see early indications of tighter finance, I want to gauge how it is gravitating toward the core.  It is at the core where these issues become more systemic, so that is vital, but every cycle has its nuance, every bubble is different.

I would argue that this type of analysis is as much as art as it is a science, and always a challenge.   Would argue some of the greatest excesses throughout this protracted cycle have been at the so-called core.  For example, there have been enormous speculative flows, especially through the ETF complex, and have fueled bubble dynamics in the S&P index, and in investment-grade corporates.

I believe the most egregious derivative excesses and associated leverage – those are right there in the arena – big cap U.S. equities and corporate credit indices.  But these areas will continue to be monitored closely for incipient instability.  We started to see that in February.

To the leverage question, we will not have actual short positions more than 100% of our account value.  So in that sense we will not use leverage, but we will certainly consider listed put options that would lift our overall exposure to the market.  Mainly, we want to be in the right stock sectors and indices that are under-performing the general market, and over time we hope to build good performance by being in the right places and avoiding outsized losses.  That is always key to our strategy.

David:  The next question is, and I will take it:

With what is going on in the markets, what do you see as the future for gold, now and going forward into 2019?

Just briefly, 2017 had record exchange-traded fund purchases of gold, the second highest on record.  Go back to 2011 and 2012 and gold is $1900.  The kind of inflows that we were seeing then, we are seeing a return to interest by investors, both in Asia and in Europe. I can tell you frankly that in the U.S. there is very little interest, and I think that is a reflection of interest in equities and a distraction by the equities market.  Equities had a dead decade here in the U.S. from 2000 to 2010 – stretch that to 2011 – you had the Dow, the S&P basically with no returns for that decade, and gold did exceptionally well, north of 10, almost 12%, annualized returns in gold.

I think moving forward, to the degree that we see a crack in the stock market, the U.S. investor will join the bandwagon and get on board with the Asian and European investor who has already seen something change and has already begun to position for higher prices in the gold and silver markets.  So, a very positive outlook for 2018 and 2019 in the precious metals, and it is somewhat commensurate with a decline in stocks, at least in so far as U.S. investors then have extra motivation to find growth elsewhere.

The next question:

How, Doug, will you position the portfolio to benefit from the moves the exchange stabilization board will make to stabilize the market volatility?

Doug:  I’m not sure about the exchange stabilization fund, but let’s think of policy responses more generally.  As I have done in the past I will carefully monitor, let’s say extensively monitor, policy responses.  There will be times when we reduce short exposure in expectation of Federal Reserve market support.  That is just going to be part of what we will have to do.  We may use options to partially hedge against the risk of a market rally.  As I have done throughout my career we might also consider long positions that we would expect to benefit from, reflationary measures, certainly including gold and the precious metals.

There will be environments where we see short risk escalating.  In the past in those environments I have avoided short exposures, I have avoided higher beta stocks, as well as stocks in sectors with large short positions.  I have liquidated put holdings in front of expected policy moves, and basically de-risked ahead of various policy responses.  This is a very challenging aspect of what I do, but at the same time it is a necessity on the short side.

David:

If long-term interest rates begin to rise due to market forces, would that cause a worldwide trend of de-leveraging of all sorts of debt, not to mention defaults?  If this were to occur, would the U.S. dollar become, in the short term, more valuable to hold?

Doug:  A couple of thoughts come to mind.  First, we are now into decades of trade and current account deficits.  We have basically flooded the world with dollar balances. The rest of the world now holds 27 trillion of U.S. financial assets, and that is from the Fed’s G1 report. That includes 11 trillion of U.S. instruments.  So this creates vulnerability, latent fragility, a future crisis of confidence in the dollar, and dollar financial claims cannot be ruled out with those types of numbers.  We have already seen market yields have begun to move higher, hedging costs are rising, and I believe we are seeing early indications of de-risking and de-leveraging.

At the same time we still see significant QE coming from the Bank of Japan, and still from the ECB.  This QE helps offset the liquidity impact of what is likely so far only modest speculative de-leveraging, but if this de-leveraging gains momentum as QE subsides, the impact on long-term yields could prove more dramatic and problematic.  Waning liquidity always exposes the limits, that’s just the way it works. Per the old Warren Buffet adage, you find out who is not wearing a swimming suit when the tide goes out.  And I will add, the longer the cycle, the greater the number of obese skinny-dippers lurking below the surface.

David:  (laughs) Thank you for that – or maybe not.  Now I’m going to try to remove that from my mind.  Some have said that the U.S. government can use inflation to wipe out its 21 trillion dollars in debt.  That would be fine if most of the debt was in 10-30 year bonds, but wouldn’t higher inflation lead to immediately higher interest rates which in turn would mean drastically higher annual debt service costs, thereby short-circuiting any attempt to inflate away the debt.

Doug:  Yes, this is such a key issue.  At this point, it basically goes without debate that governments can inflate away debt problems.  After all, they have been doing this now for the past 30-40 years.  The question is, can it continue?  There are a number of problems in this regard that I don’t think are well-appreciated at all.  For one, and this is very important, central banks don’t control a general price level.  It is kind of a myth that they can go out and manipulate a general price level.

For starters, think of the digitalized economy.  We’ve had profound changes in the nature and capacity to increase a supplied output.  This changes the dynamic for consumer price inflation.  Central bankers can spur monetary inflation if this inflation goes primarily into asset markets.  We have seen this now for how many years?  And what does this do?  It inflates problematic bubbles.  In the meantime, unprecedented loose finance internationally spurs over-investment, in China, and we have seen it in Asia and elsewhere.  And this dynamic puts downward pressure on many consumer prices.

Here at home loose finance spurred the shale revolution and all this investment in alternative energy technologies, putting some downward pressure on energy prices.  So-called globalization worked wonders in moderating consumer price inflation in the face of massive central bank stimulus, but now we seen the downside with this rise of tariffs and protectionism, along with massive government deficit spending.

We are seeing, recently, that inflation has bottomed and started to creep higher, and when this global bubble bursts, we could easily see a scenario with not only enormous deficits, but also stubborn inflation dynamics, and that is a very problematic scenario for deficits and debt service costs.  It is difficult for me not to be very pessimistic when it comes to U.S. government finances, unfortunately.  Rapidly expanding debt will outgrow inflation and I think the myth will finally be exposed.

David:  The next question is:

Within the Tactical Short, is there a framework to set up trades asymmetrically that pay off big when you (Doug) think it is right, but risk only limited capital if a bull market resumes?

Doug:  There is a strategy where you can buy long-dated puts, buy leaps and things.  It is always good to have those targeted.  And we may consider that type of an offering, a strategic focus primarily on long-dated puts.  At some point we could consider that.  That is a difficult strategy, timing is everything. Also, that particular type of a strategy doesn’t work as well as an effective hedge because if the market continues to rally significantly your puts can be so far out of the money that the market would have to drop a dramatic percent before you would start to generate good returns, so that is not a very effective hedge against the rest of one’s risk portfolio.  But anyway, it is something that we will be considering.

David:  The next question:

I have always approached derivatives with the mantra that the market can remain irrational a lot longer than I can remain solvent, thus timing is everything, ala the Big Short, or Paulson, who was lucky in his timing of the market for CDOs and mortgage-backed securities, etc., but not so much on his big bet on gold.  How do you account for this in your strategy?  Is there a methodology to reduce the risk of being wrong on the bet by simply being too early?

Doug:  Yes, I agree completely with the premise of the question, and it is a really important issue. I will throw in one of my favorite things that comes from my experience also.  Bubbles tend to go to unimaginable extremes and then double. So I have learned to presume that bubbles last much longer than we bubble analysts would expect.  I also know from experience market-topping processes can unfold over and extended period.  It can be very difficult.  So this is fundamental to our risk management focus and how we are managing short exposure today.  We carefully manage overall exposure.

Even more importantly, we are very disciplined with the composition of our short exposure.  I refer to it as strategic beta analysis management which is, essentially, managing risk based on the underlying market environment, and that is very important for today.  Currently, for example, with the acute volatility uncertainty, what I believe is a topping process, we are extra diligent with risk management, and an important part of our investment process, our methodology, is that we impose risk control on losing positions.  We don’t allow big losers.  We add winners, cut the losers.  We also look to reduce exposure when we are losing money.

David:  I think you have addressed this already, but the question is:

The short strategy – is it a hedging program that uses put options?

Doug:  Listed put options are a tool in our toolkit.  There are many times when put options may play an important role in our overall market exposure.  I have traded options now for 25 years, and I have the gray hair to prove it. These are attractive in theory. You have attractive risk characteristics in that they limit potential losses, but candidly, options generally work better in theory than they do in practice.  They tend to be very challenging instruments to use effectively.  My philosophy is to be very disciplined with options.  Many like to buy puts when they are cheap, and they have been cheap for a while.

My philosophy is to be very disciplined and not to buy them when they are cheap, but to buy them when I see a reasonably high probability of a catalyst.  And I tend to also want to reach out for more time to buy somewhat longer-dated options, assuming things will take longer to unfold than I would expect. So I generally avoid short-term options whose value is a (inaudible) 1:06:07 at least today, a rather forgiving marketplace when it comes to put options.

David:  I think it is also important to remember how easy it is to move a market in the context of days or weeks.  We have options expiration this week, maintaining a positive bias in equities through the end of the week.  That kind of market behavior is pretty common, so you can be right on a fundamental call, and if someone else has more buying power than you do, they can maintain market levels that leave your options expiring worthless.  That kind of short-term interventionism is all too common in the options market.

The next question:

Do you think ten-year rates will continue to rise?  If so, is that what is going to prick the bubble after some bank failure, ten-years may or may not fall, but until then is it going to rise?

Doug:  Yes, I believe ten-year yields are going higher.  Today, bonds were under pressure again.  Again, that 3% bogie in the ten-year treasury is not far away now. You also see inflationary pressures are building, the Fed is moving more decisively toward normalization, and there is this massive, and it appears unending, supply of government debt in the pipeline.

Then we have the safe haven bid in treasuries, though.  It could return if all of a sudden we see heightened systemic risk.  We have to be aware of that, and that would be almost a normal development.  So I believe ten-year treasury yields remain depressed in the current environment because the bond market is sniffing out trouble in the risk markets today, down on the horizon there.

We saw this dynamic in 2007 and other periods, the old Greenspan conundrum.  To me, it was never much of a mystery.  Long-term treasury yields are keying to bubble risk, the probability that within a limited number of years the bubble with burst and the Fed will come with lower rates, likely resulting in more QE.  The problem is, again, we saw this in 2007.  The bond market is sniffing out trouble, works to keep market yields low enough to extend late cycle bubble access.  So I think yields are going up.  Easily, treasury yields could reverse and go lower in a risk-off environment, and we could just see extraordinary volatility in the treasury market, I think.

David:  The next question.

I remember Trouchet getting frustrated with Bernanke when the ECB raised interest rates in 2012 and the Fed backed off raising rates.  This caused Portugal, Italy, Greece and Spain to run into trouble.  Is the current trade war about forcing the ECB and China to raise their interest rates? (This is the first part of the question).  I understand China is only raising it by five basis points at a time.  The Bank of Japan and ECB are probably speculating that the Fed might stop raising rates sometime soon.

Doug:  I believe the issue with Trouchet goes back to the ECB’s controversial rate increase back in 2008. The Fed was in the easing mode then, but at the same time crude had surged to $140 per barrel and the inflation risk was percolating, so the ECB stepped up and raised rates, and they were criticized for it.  But the financial crisis in the U.S. sparked a de-risking and de-leveraging which exposed all the excesses in Greece, in particular, and in the periphery in Europe.  That bursting of the Greece bubble put pressure on Portugal, Italy and Spain and became a full-fledged crisis in 2011-2012.

Not coincidentally, that is when the Fed was preparing its so-called exit strategy from QE.  In 2012 the ECB president, Draghi, desperately resorted to “whatever it takes” in tandem with the Bank of Japan, the Fed, and others. The rest is history.  I don’t think the Fed has a lot of expectations for these other central banks to raise rates much.  I think a lot of these central banks now are more focused on domestic policy-making.

David:  It impresses me, Doug, that the framework has been laid out in the Scandinavian countries, in Europe, and we have flirted with the zero bound.  There are certain scenarios in which closure of the financial system and more financial repression via negative rates are not entirely out of the question.  They have exercised that and sort of gotten the machinery in place.

Michael Woodford at Columbia University and Ken Rogoff are still advocates for getting rates to the negative in nominal terms so that they can goose the economy just as one more tool in the toolkit. It presumes a lot about their control of the markets and interest rates, but that is what you get with Ph.D’s is quite a bit of presumption.

The next question is:

If a 1929-like event – I believe the payment system crisis actually happened in 1931 when the Fed raised rates as it happened, relieving itself of being the lender of last resort – were to happen, if those events were to happen, is your fund going to be protected from bank failures? 

So keep that in mind, and then he has a little addendum here:

Gaining on shorting is one thing, but keeping it seems more important, as it appears client money being co-mingled everywhere, and with most funds seeming to be creditors to the banks.

So maybe you could shed some light on that.

Doug:  Excellent question. First of all, we specifically chose to use a brokerage that is not involved in proprietary trading or managing a book of derivative exposures.  So that is one of the keys right there, a broker who is not part of a big, diversified global financial business.  We chose a brokerage with conservative risk-focused management, and that is imperative.

This has been a long-term concern and practice. I have gone through a few cycles and I have yet to experience an issue with a prime brokerage failure or counter-party problem.  I specifically want to avoid all of that and our analytical framework hopefully gives a little bit of a heads-up where to avoid.  These are all types of risks that we focus on more than others in the marketplace.

As far as the co-mingled funds, in an environment of rising system risk we can do things.  In particular, we can put our cash in T-bills.  We will not have co-mingled funds.  That is not a game that we would be willing to play.

David:  The next question relates to the Federal Reserve’s responsibility:

Is it the Federal Reserve’s responsibility to prepare the bond market for massive new issuance in order to fund government’s ambitious spending plans, or to protect the dollar, or to maintain market stability?  And if they cannot to do all three, which do they choose?

Doug:  This is an area that I can get a little worked about, but I’ll try to stay calm (laughs).  It is the responsibility of the Federal Reserve to maintain financial stability.  The rest of this is more nebulous.  Regrettably, the Fed equates the rising market prices with stability. While they do this they disregard all varieties of problematic excess and that includes speculation, leveraging, the market misperceptions, resource misallocation.  So over the years central banks have promised too much and they have intervened in markets too much and too often.

All of this has nurtured a view that they will do whatever it takes.  They will take rates to zero or lower if necessary.  They will monetize government, private sector debt, if necessary.  They will maintain low market yield, high stock prices.  They will assure liquidity abundance.  They will even ward off bear markets and recessions.

The problem is that all these assurances, these promises, these guarantees, have all spurred market excess and economic maladjustment.  The perception that they can control everything has ensured a degree of deep financial, market, economic – all of this – deep structural maladjustment that they will not be able to control when the bubble inevitably bursts.

I believe the over-riding challenge for central bankers will come in the liquidity sphere.  That will be their primary focus.   During the next year’s de-risking de-leveraging episode, I anticipate they will likely have to inject enormous amounts of liquidity, and that is just in order to accommodate de-leveraging.  It would not surprise me if this spooks long-term bonds and destabilizes currency markets and faltering risk markets will hold the central bankers hostage.  So I think the days of them making everything right are winding down.

David:  This next question – I am glad it was asked.  Folks have read you on the Prudent Bear website and have seen your Credit Bubble Bulletin for years.  This person says they started reading you in 2001.  Their interest is for historical research.  Where can they go to look at your articles, essays and reports in an archival form?

Doug:  I appreciate that. I was saddened to see prudentbear.comshut their site down.  But I do have all of my archives going back to 1999, almost 20 years, and those are available at my blog.  That is creditbubblebulletin.blogspot.com.

David:  Great.  This is a question from a trader, and it is similar to the one we were talking about earlier about counter-party risk and the issues with proprietary trading.  He says:

I had a trading account with (inaudible) 1:17:00 Financial, which was purchased by MF Global.  You know what happened later to MF Global.  When the force major is declared on the dollar, it will undoubtedly collapse debt and equity markets here in the U.S. and crash markets globally.  As a trader, my concern is over the network of brokerage firms handling all the trades.  They could all go bust.  Do you think it is a legitimate concern, or am I overly concerned?  What are your thoughts on that in consideration that a short portfolio has to hypothecate their shares to participate, or are you using futures?  And if using the latter, how do you feel about counter-party risk with futures or options contracts?

Did you get all that, Doug? (laughs)

Doug:  I’m scratching down notes here, quickly.  Yes, what a nightmare that must have been.  I believe we are heading toward a more challenging financial crisis than 2008, so I think all such concerns are legitimate. Specifically, in regard to shorting, we borrow shares instead of lending them, so I don’t worry about lending securities and then not being able to get them back.  That is not an issue for us.  In 2008 regulators banned the shorting of financial stocks, so in certain environments we have to be mindful of trading halts and restrictions on shorting, and that can impact our trading.

Because of the complexity of contemporary securities and derivatives markets, though, I think a total ban on shorting would be extremely problematic for the markets.  It likely would only occur after a crash, and at such a point our focus would be on protecting our cash.  I would expect at that point that we would be owning short-term treasuries.  I am always mindful of counter-party risk. For years I have avoided third-party derivatives.  I haven’t had an issue with that.

We will use ETFs instead of futures contracts. We will purchase liquid listed put options, but these must be managed diligently in a crisis environment. What does that mean?  That means a disciplined approach to taking profits.  I call it extracting cash – take money out, deepen the money puts, roll our strikes lower to reduce our risk.  When practical, we will extend maturities.  The amount of option market value must be monitored and managed prudently, especially in a crisis-type environment.

David:  The next one:

What do you think of that flat yield curve?

Doug:  A flat yield curve. Well, you know, as I mentioned previously, I think the flat yield curve is a long end, recognizing that risk of faltering markets is high, that over the coming few years there is a significant risk of a bursting bubble, so I think we’re getting closer.  How close is an open question.  Right now lower market yields are lending support to the risk markets, and these markets are supporting economic growth, and with it, central bank policy normalization.

We saw in 2007 how the initial about of volatility in the subprime issue led to a big rally in treasuries and agency debt which prolonged the bubble for a bit of time, but in the end only made it worse. So all of these types of dynamics – the market instability creates great uncertainty.  The wild volatility in my mind is indicating that we are very late in this market cycle.

David:  This will be the last question and then we will wrap up.  This questioner asks:

Not long ago I was speaking with an introducing broker, and discovered that the European currency trading firms have been forced to reduce trade leverage to lower levels.  Looks a lot like they are preparing for something.  Any thoughts?

Doug:  Well, they should be preparing for something.  They’re not oblivious to the potential instability associated with curtailing QE and beginning to move toward a more normalized policy regime. Especially, the periphery Italian yields could be one of the most over-valued fixed income instruments in history.  So of course they would be battening down the hatches.  So far, the  market has cooperated with them, but we saw today that the rise in U.S. yields also transmitted to a rise in periphery yields in Europe.  So maybe they are not that far away from instability over there, as well.

David:  Well, Doug, as we wrap, just some general observations.  As we talk to business professional, asset managers, and those with fiduciary responsibility, over and over again we keep on getting feedback like this: “We had our hundred-year flood in 2008, and it’s done.  We’ve got 100 years of peace and prosperity ahead of us.  Having logged one of the greatest financial crises in 100 years, how can we expect to see something like that happen again?” That is one thing that we keep on finding is that you certainly are not going to have lightning strike twice, not that soon.

Another observation is:  “Yeah, we probably are in somewhere between the eighth or ninth inning of the game, but we still have time, and while we have momentum we’re going to keep the positions in our portfolios as they are.”  This is based on a presumption that they can, and will, have time to react.  Off the cuff, do you have any thoughts on that notion of being up to the wire in terms of having a portfolio hedge in place, or would you agree with the proverbial “better to be three months early than a day late?”

Doug:  We’ve seen a number of flash crashes.  We saw the market instability in February.  When this unfolds it could unfold rapidly, abruptly. Most people will not be prepared to de-risk.  They won’t have good, viable options to hedge the market risk.  So we say, David, it’s time to take this seriously and to get ready with a strategy to preserve capital, hedge our risks, and prepare for a changing market environment.

David:  I would encourage anyone listening, if you would like to set up a time to visit with either one of us, Doug or myself, we would be happy to do that over the next few weeks, and on a consultative basis figure out what risks you are trying to hedge and what the appropriate way to do that would be, if the Tactical Short is a fit for you, to the degree that it might be or not.  We love what we do, and we love helping people.  So please take us up on the offer of spending a few minutes to visit with someone on our team to see if this is the right fit for you.

We appreciate your time today on the conference call.  We look forward to any questions, if you feel we’ve missed something or this stirs further questions, feel free to send those by email and we will either respond by email, or if you will provide us with a direct number we will give you a call back and schedule something for the next week or so, so that we can fully explore that.

Thanks for joining us here.  We finished our first year for the Tactical Short – a full year’s management – in the context of ten years of asset management in the current form, and 46 years in helping people hedge portfolio risk. We appreciate the time you took today.  Please make it a priority to continue the conversation and see where you can, and should be, hedging.  Thanks for your time today.

Doug, thanks for joining, and we look forward to the next quarterly conference call in a quarter’s time.

Doug:  Thanks, David. Thanks, everyone, and good luck out there.  Take care.