David: This is the second quarter for McAlvany Wealth Management Tactical Short, July 19, 2018. A warm welcome to our clients who have joined us today, as well as guests from across the country and around the world today.
I will give you an overview of where we are going to be today, which is Doug leading the charge in the conversation on a macro perspective from a credit perspective and looking at a number of issues which are driving financial markets and some of the frailties within the financial markets here as we finish the second quarter and the first half of 2018.
After Doug is done with his formal remarks, we will have time for Q&A, and for those of you who have already submitted questions we will address all of those and there is also the opportunity to submit questions while we are in that stage of the conversation, as well. Feel free to do that online. I believe you can do that through our website, mwealth.wpengine.com. There is a chat function there and it will populate on my computer and we will answer those questions as we go through.
This is a very interesting period of time for us as a management group, and for Doug on the Tactical Short. We have trade and tariffs and the continued expression of national self-interest, both here in the United States and in many places around the world. We are also beginning to see monetary tightening and seeing that in more than one jurisdiction. It is odd to talk about monetary tightening when you look at where we are relative to what was considered normal in decades past.
This is still a highly accommodative monetary policy backdrop; nevertheless, we are beginning to see some tightening here in the United States, and of course, we have the promises from the European Central Bank to begin to change the backdrop in Europe, as well, limiting asset purchases as we head into September, and then eliminating them altogether by the time we get to December. Big changes ahead for the ECB as Draghi steps away and it will be interesting to see who actually takes the position there as leader of the ECB.
Another interesting and very important element in the current backdrop is U.S. dollar strength. What this is revealing globally is what is called the original sin. The original sin is where debtors the world over choose to issue debt but they don’t issue that debt in their own currency. They issue it in a foreign currency. So we have a tremendous amount of U.S. dollar-denominated debt which either is due or rolls over by 2020, roughly 900 billion dollars of emerging market debt in that category, and actually, quite a bit more which has been issue with longer maturities.
The challenge is, of course, going back to that notion of the original sin, because it was denominated in the wrong currency to begin with, as the dollar appreciates and foreign currencies depreciate relatively speaking, the hurdle to pay back becomes much more difficult. So some of the stress that you have seen in the emerging markets, to the degree that the U.S. dollar continues to strengthen you can expect to see those pressures increase overseas. So, definitely on our radar, and Doug will address more of that as we get into his formal comments.
We also are in the first month or so of seasonal weakness within the equities markets. Not everything is perfectly relevant coming from the Stock Trader’s Almanac, but up through October, from April to October, typically, is the weak period in equities. And then from November through May, typically, you have stronger market returns. So we have some seasonal weakness here in the equities markets which really has nothing to do with the backdrop issues we’re going to be talking about today. It is more coincidental that we happen to be in that period of time.
And I would say, it’s not mere coincidence that June and July, typically, are the lows for the precious metal sector, as well. So that, I think, is the worst behind us. That remains to be seen, but certainly, we typically put in lows in this kind of a seasonal period, as well.
We will be looking at a variety of topics here in a minute but while I’m on the issue of precious metals I think it is worth looking at the entire commodities complex and the great contrast between 2017 and the verbiage we were getting from the mainstream media there versus 2018. We had global growth on a comprehensive basis, and that was kind of a theme in 2027, and I think it is very hard to argue for global growth and the acceleration of that growth here in 2018. Look at commodity prices, look at Dr. Copper. What that is telling you in terms of global growth as we head into the third and fourth quarters, I think, is very important to keep in mind.
Bringing things back here to the United States, just points that I think are worth keeping in mind, margin debt here in the United States is back near its all-time highs, both as a percentage of stock market capitalization, as a percentage of GDP, and of course, in nominal terms, as well. Far surpassed here at 668 billion, the much smaller numbers back in 2000 and in 2007, again, on all three metrics relative to stock market capitalization, relative to GDP, which gives you some relevant perspective if you’re looking back to the 1920s and things like that.
All that to say, there is a lot of speculation in the market today, and a lot of complacency in terms of the downside risk. When you’re borrowing money from the house to speculate on what you consider your sure bet, and you’re doing it in record numbers, again, it is just worth keeping in mind, we have far surpassed where we were in the year 2000 and in the year 2007.
Doug, I want to get you in here to begin your comments, and then I will pipe back up in the Q&A with some of the relevant questions that I can answer, but again, thanks, everyone, for joining us today.
Doug: Thanks, David. Hello everyone. Thank you for joining this afternoon’s call. As always, special thanks to our account holders. We greatly value our client relationships. For those unfamiliar with tactical short, detailed information is available at mwealth.wpengine.com/tacticalshort. Let me begin with an overview.
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. This strategy is designed for separately managed accounts. We will short security stocks, ETFs. We will also on occasion buy liquid and listed put options. Shorting entails unique risks.
What sets us apart is our analytical framework and uncompromising focus on identifying and managing risk. We tactically adjust short exposure. We expect to generally target exposure between 50% and 100% short. Our current short exposure is 60%. We believe current market downside risk is extremely high, but we also recognize the risk of being short is unusually elevated. We believe a 5% to 20% allocation to Tactical Short today is integral to a well-diversified investment portfolio.
We are not recommending aggressive bearish bets against equities. We never do that. But we do see a highly speculative environment that beckons for a disciplined approach to risk management. We are currently positioned defensively, but there will be environments where we will opportunistically seek outsized returns. Generally, however, this strategy will endeavor to have less volatility, a lower portfolio beta than the U.S. equities market. I have been managing short exposure now going back to 1990. Tactical Short is unique in the marketplace. We believe we have the soundest structure and process for today’s highly unsettled environment.
We have structured Tactical Short to ensure the flexibility to navigate through even the most difficult market conditions. The second quarter was extraordinarily challenging on the short side, and we got through it without too big of a hit financially or emotionally. A lot of blood was spilled on the short side during Q2.
Let me repeat what I stress in every call. Remaining 100% short all the time, as most short products are structured, is risk indifference. Risk indifference on the short side is a game of Russian Roulette. Few products adjust the amount and composition of short exposure based on evolving risks. Q2 proved once again that macro risk analysis is absolutely imperative.
I will update performance. Tactical Short accounts, after fees, lost 2.52% during Q2, but S&P 500 returned positive 3.43. As for one-year performance through June 30th, Tactical Short was down 5.36% versus the 14.36 positive return for the S&P 500. We regularly track our performance versus three actively managed short fund competitors. First, the Grizzly Short Fund which lost 8.13% during Q2 – that makes one year performance for Grizzly down 18.45%. The Ranger Equity Bear Fund was down 5.57% for the quarter – comparable one-year down 8.88%. The Federated Prudent Bear Fund lost 8.30% for the quarter – it was down 16.02% for the year.
We benchmark performance versus the inverse of the S&P 500. Over the past year, Tactical Short’s 5.36% decline was about 37% of the inverse of the S&P 500’s return. For Q2, Tactical Short outperformed the three competitive funds by an average of 481 basis points. Over the past year Tactical Short outperformed by an average 909 basis points. We have lost money, and that is disappointing, but I will try to explain why we have outperformed competitor strategies.
When we structured this product, having the flexibility to be tactical was the top priority. What do we mean by tactical? We are going to use our analytical framework and experience to actively gauge risk versus return when we make key portfolio decisions. First, what percentage short do we want to be? Is our general posture defensive or opportunistic? What expected portfolio beta are we willing to tolerate? What is the preferred composition of our short exposure? Are we short stocks? Is the risk versus return for shorting stocks attractive or unattractive? If it is viewed as unattractive we’re not going to do it. It is as simple as that. This sets us apart.
Are we short sectors? Are we short the broad market indices? Are we buying listed put options? We look to options when we see enticing opportunities. If we don’t see them, we don’t buy. We won’t be wedded to a specific short exposure strategy either by mandate or emotionally. We won’t be short, operating as a market hedge, but we are keenly focused on the risk versus potential reward calculus for determining the composition of our short exposure. We strive to be a wise hedge, refusing to blindly follow some pre-programmed blueprint.
Our competitors are pre-locked into their individual strategies. It might be concentrated individual company shorts, or it could be shorting mainly small cap companies, or running a portfolio of individual company shorts and longs. Neither macro analysis nor market dynamics apparently figure much into their positioning decisions. We have structured our product to be different in this regard. The market backdrop has a major impact on the amount of our short exposure and, as importantly, its composition. Macro and market analysis is fundamental to portfolio construction.
The second quarter illuminates why we believe in our process. Our macro view heading into the process held that we were operating in highly uncertain market-topping process within a backdrop of vulnerable bubbles spanning the globe. Our analysis warned of an unprecedented environment with a high probability for volatility and wild shifts in market perception, sentiment and positioning. More specifically, we believed there was a high probability of a risk-off dynamic erupting. Such a development would significantly increase the odds that hedge funds might suddenly find themselves on the wrong side of crowded trades, both with their longs, and more importantly from our perspective, with their short positions.
We gauged the risk of a major short squeeze as unusually high, meaning the risk of shorting individual company stocks was highly elevated. This analysis dictated the composition of our short exposure. We saw opportunities for a market downturn, yet the risks versus reward for shorting individual stocks remained unattractive. As it turned out, a powerful short squeeze unfolded during the quarter. The Goldman-Sachs Most Short Index surged 15% during Q2. For example, the New York Arca Oil Index jumped 14.3%, the retail stock index gained 10%, the REET rose 6.8%.
The broader market outperformed, small caps rose 7.4%, and the NASDAQ composite gained 6.3. Many popularly shorted stocks went ballistic. Twitter was up 50% during the quarter, (inaudible) _00:15:53_ 47, Netflix 33, Macy’s 26%, Chesapeake Energy 74%, to name a few. Tesla, with over 39 million shares short, jumped almost 100 points.
I will briefly comment on short squeezes. Candidly, they are a real pain. They erupt on occasion in the marketplace, often just as you discern bearish fundamentals beginning to take hold. I have had to persevere through squeezes throughout my career, going back to an unforgettably brutal squeeze in 1991. They tend to be highly disruptive. I liken them to a tornado that quickly blows through, wreaking havoc along the way. They are not discussed much on the short side, though it is integral to our risk management strategy to try to avoid the pain and disruption of getting run over by squeezes.
During the quarter we were only short the S&P 500. I have been asked why I would structure short exposure this way. Q2 might help with my explanation. I am never excited about shorting just the S&P index, and frankly, it is unhelpful from a marketing perspective, but our investment process specifically doesn’t factor in marketing, or my emotional state, in portfolio composition decisions. The unsettled backdrop has been ripe for a major short squeeze, making the risk/reward calculus for being short the S&P 500 relatively more favorable than getting caught with a portfolio of individual stocks into a squeeze. In high-risk backdrops for shorting, the S&P 500 short generally wins by default. This is fundamental to portfolio beta management.
We outperformed the actively managed bear funds, chiefly because we averted the squeeze in individual stocks. But I will add that the S&P 500 was the preferred vehicle for fundamental reasons. S&P companies have significant exposure to the emerging markets, to global financial and economic turmoil, and to potential exposure to tariffs and trade issues.
Let me segue from portfolio composition to macro analysis. As many of you are familiar, my thesis holds that we are in the throes of history’s greatest global bubble. It is also my view that the global bubble was pierced at the periphery during the second quarter. Global financial conditions tightened meaningfully.
I will offer a few data points. Let’s start with the emerging market currencies. The Argentina peso collapsed 30%, forcing the Argentine government to request a 50-billion dollar IMF bailout. Brazil’s real sank about 15%. The Turkish lira and South African rand 14%. Yields spiked throughout EM – almost 400 basis points in Turkey, 200 basis points in Brazil, and 100 basis points in Indonesia and Hungary. In general, equities sank and risk premiums spiked throughout the emerging markets.
As David mentioned, the dollar index abruptly jumped 5.2% during the quarter, catching the emerging markets, leveraged players and traders off guard. Faltering local currencies quickly led to fears for EM exposure to dollar-denominated debt. I believe there is a huge speculative leveraged trade on globally and what has been a proliferation of EM carry trades, and many of these leveraged speculations have come under intense pressure. Fragility re-emerged in China during the quarter. The Chinese renminbi declined 5.2%. In equities, the Shanghai composite lost 14.7% and China’s ChiNext index sank 15.5%. China’s two largest banks saw their stocks drop 13% and 16%.
China is now six months into a meaningful slowdown in credit growth. Beijing has clamped down on shadow banking and credit availability has tightened for China’s high-risk corporate borrowers. At the same time, household borrowing has continued to surge as China’s runaway apartment bubble inflates to dangerous extremes. In short, key facets of China’s historic financial and economic bubbles are indicating heightened fragility. Markets maintain confidence that Beijing has everything under control. I counter that bubbles that are left to inflate to such magnitude eventually turn uncontrollable.
It is not discussed much, but over the past decade China has become a major trading partner and lender throughout the emerging markets. The fates of these two bubbles are now conjoined. I will add that the unfolding trade war comes at an especially inopportune time for both China and the emerging markets. Currencies and equities were weak throughout Asia during Q2 as markets assumed a more cautious approach to indebted companies, countries and regions. There was a significant widening of credit spread and indications of waning liquidity in China and throughout Asia.
But it was not only Asia. Latin America and Eastern Europe also experience heightened financial stress. Almost across the board there was significant weakness in banking and financial shares which is supportive of my macro thesis. After being on the receiving end of record inflows in 2017 and into this year, EM suffered a sharp reversal and the largest outflows since 2016’s unstable backdrop.
It is easy to forget that ten-year treasury yields reached a multi-year high, 3.13%, about halfway through Q2. The booming U.S. economy had the markets contemplating more aggressive monetary tightening. (inaudible, s/l surging) _00:22:13_ yields and the stronger dollar hammered a vulnerable EM. Hot money abruptly moved to the exits as de-risking, de-leveraging dynamics took hold. Underlying fragilities having accumulated for a decade or more were suddenly exposed.
The Institute of International Finance recently reported global debt into the first quarter at a record 247 trillion dollars, or 318% of GDP. After a decade of historic credit inflation, global debt has continued to grow at double-digit rates. Global debt has expanded 150 trillion, or 150% over the past 15 years, similar to the trajectory of growth during the mortgage finance bubble period. Global debt growth accelerated during the first quarter to 8 trillion, and surged 30 trillion over just the past five quarters, exactly the type of manic excess that sets the stage for turmoil. Worse yet, the first quarter saw emerging market debt rise by 2.5 trillion, or about 18% annualized, to a record almost 59 trillion dollars. EM corporate debt surged 1.5 trillion, or at about a 25% annualized rate, and now exceeds 94% of GDP.
Trillions of dollar-denominated EM debt have been issued in recent years, and as David mentioned, 900 billion is said coming due by 2020. From my analytical perspective, EM experienced one final period of blow-off excess, ensuring the crisis backdrop that began to unfold during the quarter. But here is where the analysis gets interesting, as well as challenging. It is my view that cracks at the global bubble’s periphery have worked initially to bolster the core.
Here in the U.S. the abrupt downturn in EM currencies and markets spurred a big reversal in treasury yields, along with an up-tick in hot money flows to U.S. securities markets. This abrupt change in market dynamics caught the leveraged speculating community poorly positioned. There was a big short squeeze in the treasury market. The reversal of hedges created a shot of liquidity that altered market dynamics. Suddenly, many were on the wrong side of scores of crowded trades.
Hit with sudden losses, speculators were forced to take risk down on both long and short portfolios, as de-risking, de-leveraging dynamics took hold. A market dynamic unfolded where the hedge fund favorite longs were under-performing the market, while their favorite shorts were out-performing, a big problem for many strategies. The way I see it, liquidations on the long side were offset in the market by company buy-backs and other inflows.
Meanwhile, the reduction of short exposure placed major pressure on shorts generally, and incited what developed into a major short squeeze, the aggressive buying of shares to mitigate losses. This backdrop has ominous parallels to how the eruption of subprime back in 2007 incited a bout of monetary disorder that saw record equities and MBS prices only months before the 2008 crash. In particular, current monetary instability stoked a rally and performance chasing flows into some of the most liquidity-vulnerable areas of the securities markets – high-yield credit and small cap stocks.
In my nomenclature, cracks at the global periphery had extended the terminal phase of excess at the core. This dynamic creates a major dilemma for the Federal Reserve. Despite seven 25 basis point rate increases, easy financial conditions continue to intensify the U.S. boom. The more speculative areas of the markets are booming. We looked at biotechs up 21%, the NASDAQ 100 15%, and the small caps were up 11% through the first half. Leveraged lending was red hot toward M&A activities on record pace.
Home price inflation has accelerated as hot markets rekindle memories of 2006. Commercial real estate price inflation has gone to extremes virtually across the country. During the Q1 recap I drew parallels between the blow-up of the short fall strategies and the initial eruption of subprime back in June 2007. I see the Q2 eruption of EM instability as the second phase of the unfolding bursting global bubble. The financial press is rather fixated on the U.S. yield curve, recently noting that it has turned the flattest since August 2007. Conventional analysis holds this is an indicator of looming recession.
Back in 2007 I viewed the flat curve as more of a warning of bubble fragility and an indicator of imminent recession. With U.S. mortgage finance at the epicenter of excess back then, the bursting bubble did coincide with an abrupt halt to U.S. credit and economic expansions. I view today’s flat treasury curve as again signalizing bubble fragility. The major difference, however, is that global finance is at today’s bubble epicenter. Heightened fragility in China, Asia, and EM more generally, risks global financial turmoil and economic vulnerability.
From my analytical perspective, global bubble dynamics continue to follow the worst case scenario. Bubbles in China and throughout EM went to unprecedented extremes. Now cracks at the periphery worked to prolong dangerous excess at the core, (inaudible) _00:28:40_ asset inflation, market misperception, speculative bubbles, unrelenting debt growth, and deepening economic maladjustment. That cracks would appear in EM despite the still ultra-easy global monetary backdrop portends challenging times ahead.
To this point, EM has been supported by the large international reserve holdings accumulating during the boom. But these hoards can be depleted in short order. The powerful U.S. equity short squeeze creates vulnerability to an abrupt reversal, as they say, crisis up on air. I vividly recall short squeezes preceding a 1998 global financial crisis during Q1 2000 right before the bottom fell out of tech stocks, and in the fall of 2007 not long before all hell broke loose. These days many big cap tech stocks are in manic speculative blow-offs. Along with the short squeeze there is surely a derivatives component.
With a proliferation of option trading strategies it is likely that speculators have been caught on the wrong side of previously out of the money call options, all reminiscent of early 2000. The out-performance and resulting flows into less liquid securities is also problematic. Speculative trading dynamics have created a backdrop where a market reversal could abruptly lead to illiquidity and dislocation. I am also very concerned about the ongoing excess throughout U.S. corporate credit, in particular, the boom in triple B, the riskiest investment grade bonds recalls the final blow-off in investment grade mortgage credit in the months following the 2007 subprime eruption.
U.S. economic optimism remains highly elevated despite risks of a full-fledge confrontation on trade. At the same time, underlying market and financial fragilities go unrecognized. Do you appreciate how the global boom has been underpinned by unsound finance? The extraordinary backdrop creates a major dilemma for the Fed. Financial conditions remain too loose for the overheated U.S. economy. So far gradual rate hikes have worked to only bolster U.S. market and economic bubbles. The upshot is a stronger dollar and additional pressure on faltering EM bubbles. U.S. market resilience likely bolsters Chairman Powell’s determination to normalize interest rates.
I expect the stress at the global periphery, notably EM and China, to deepen. The global backdrop is turning increasingly ominous. These are truly historic bubbles and their unfolding demise portends momentous consequences for markets, economies, societies, and geopolitics. U.S. markets, at this point, assume all is clear, at least through mid-terms. These have to be the most complacent markets I have witnessed during my career. The world could be on the verge of unprecedented financial turmoil. The global economy may be at the cusp of a major downturn with limited policy recourse, on the verge of a trade war and heightened geopolitical instability. And depending on the results of the mid-term elections the U.S. could be at the brink of political mayhem and a constitutional crisis.
I believe the emerging markets have succumbed to the downside of a historic financial boom. It is my view that strains in China portend a wrenching financial and economic adjustment. As I have said over the years, bubbles are mechanisms of wealth redistribution and destruction. Seeing unmistakable cracks in the global bubble, I worry increasingly about the deteriorating geopolitical backdrop. I am also fond of saying that my job is not to predict, but instead to have the proper analytical framework, the intense focus, and sound investment process to be able to react successfully to developments. I am ready for what should be a fascinating second half of 2018.
David, back to you for Q&A.
David: Again, the primary concern here is that as we see instability grow in financial markets, that migration from periphery to core and the instability we see at the periphery finds its way to us. So what may be better for us in terms of either a strengthening dollar, or what have you, ends up being worse for everyone us. The challenge is, of course, that we live in a highly interconnected world. So the risk of a major credit crisis spreading from the emerging markets, perhaps migrating to Europe, and then ultimately being on our shores, becoming a real comprehensive global concern – that domino effect is very relevant and remains a high probability.
So, to the questions, let’s begin, Doug, with a question on LIBOR, the interbank lending rate:
Libor, the interbank lending rate, is due to expire in the year 2021. What is the reason for this, and does this have anything to do with a reset of the entire financial and/or currency systems?
Doug: LIBOR – that’s the lending rate set by select groups of banks. It has had serious issues now for years and that is including manipulation, collusion and fraud. So I don’t really see that this phase-out is part of any master plan. It was always difficult for me to comprehend why there wasn’t a better mechanism for compiling an index of average short-term interest rates. I don’t really expect to lose any sleep about the demise of LIBOR.
Coincidentally, the New York Times had an article this morning with the headline, “The most important number in finance is going away. Wall Street isn’t prepared.” It quoted a number of 200 trillion dollars of derivatives linked to LIBOR. The article asked the question, “What will replace it?” And then answered, “Nobody knows for sure.” So this is a really important issue. We will be hearing a lot about it going forward, and a lot of uncertainty as they try to figure out a new index for credit instruments.
David: Doug, the next question deals with markets in the context of chaos:
How would your Tactical Short offering function in terms of its trading mechanics, on chaotic, big down days?
Doug: I assume that some of those mechanics are referring to circuit breakers and trading halts, and I will say for the most part I am okay with such mechanisms that are meant to contain wild intra-day volatility and market dislocation. I am never, of course, overjoyed when the market halts trading – that can be in stocks or the entire market. But in the past these haven’t tended to have much impact on my trading. We don’t aggressively trade intra-day. We will adjust our exposure, but if the market is halted, that wouldn’t cause me much grief.
I actually have a bigger issue with the proliferation of derivative strategies that are essentially providing market insurance. There is all this attention given to trading halts and things like that, but little attention is given to all the portfolio insurance type strategies that contributed even to the 1987 stock market crash. I believe the issue today is so much bigger than it was back then. So my big concern is with market structure rather than circuit breakers.
The whole concept of rigged market trading bring another thought to mind. One of the problems associated with prolonged financial bubbles is the concentration of financial power. Today you have these individual firms that literally control trillions of dollars of assets. And do I believe there is any incentive during periods of chaotic trading for the big players to come in and stabilize the marketplace? Of course there is incentive to do that. One could consider it market manipulation, but I just tend to look at this kind of thing as a natural occurrence of these types of bubbles. It was a major issue in 1929 and I believe there will come a point when folks will look back and question why it ever made sense to have central banks manipulating finance to the point of ensuring such a concentration of market power and influence.
David: Doug, this is my question, not on the list submitted by our listeners and those who join us today:
Who is to say that market rigging doesn’t continue indefinitely? With the introduction of algorithms and the elimination of market signals, in terms of the control of pricing, why doesn’t it continue?
Doug: David, I thought you agreed ahead of time to only ask easy questions (laughs). I always have the view that even looking at the central banks, they can backstop markets, they can protect bubbles, and the bubbles eventually get too big for them to control. And even in the marketplace today, let’s say the big players come in and manipulate prices at times and stabilize market prices at times. In the meantime the ETF complex, globally, has grown to 5 trillion. Performance chasing, trend following, derivative trading proliferates. So I think the problem gets bigger the more you have this artificial stabilization of the markets, and eventually, that can lead to an uncontrollable panic because the size of the selling just becomes so massive.
David: No one is large enough to take the other side of the trade. Following up on the question before, do you think that some markets might not be able to reopen after a chaotic crash?
Doug: I believe the risk of a major global liquidity even is high. There has been this proliferation of all these sophisticated derivative strategies that depend on what they call this dynamic delta hedging, which basically means that there is a computer algorithm that will create sell orders in declining markets and buy orders in rising markets. The problem comes when you have a market breakdown inside a self-reinforcing cascade of sell programs. And now the hedge industry is 3.2 trillion dollars, so I don’t think you’ve ever had this type of trend-following trading in the marketplace, in the funds, and in derivatives. I hope I’m wrong in this, but I see it as an accident in the making and in the event of a global financial crash it wouldn’t surprise me at all if there were markets that remain halted for a period of time.
David: The next question is:
Where in the world would you anticipate the downturn starting?
I’m taking it that this question is coming from Australia because the follow-on is:
How will it affect Australia?
Doug: I think we have started to see it in the emerging markets and I think the big surprise could be if you get a dislocation in China and you see a rapid slow-down in the Chinese economy. Unfortunately, I fear Australia is heavily exposed to unfolding developments in both EM and China. We have already witnessed weakness in the Australian dollar, and certainly in commodities prices. I love Australia, and candidly, I worry about what I, and others, believe has been a major and protracted housing bubble.
My biggest fear would be that the impact from faltering bubbles in China, in the end, would prove the catalyst for piercing Australia’s housing bubble. That would have major ramifications for the markets, economy and their banking system. That scenario would be really problematic for Australia, and generally, I would be concerned for housing markets around the globe that have been targets for international buyers, certainly including major cities in Australia.
It looks like we have had an audio problem so I will continue here with the questions. I’ve got a list. Next question:
Are we still unable to call the direction of the brake, inflation or deflation, or is one direction becoming more obvious?
I don’t expect my answer is going to be very satisfying. For years I have argued that the issue is much more complex than simply inflation versus deflation. Lately, dollar strength has put some domino pressure on global commodity prices. This is spurring deflation fears in some EM economies and inflation concerns in others. Meanwhile, asset price inflation runs unabated in the U.S. and other developed nations.
Looking into the future, I believe a lot will depend on the dollar. Right now we are seeing this King Dollar mode again, but the dollar has serious fundamental weaknesses, including large current account deficits – these huge foreign liabilities and what we believe is an unfolding fiscal train wreck. So if the dollar gets in trouble this could certainly prove inflationary here in the U.S. In the past I have argued that we need to wait to see how things unfold. So to answer the question more directly from my perspective, I would have to say I am leaning toward higher inflation right now, but China could be a big wild card.
Given the six-month decline in emerging markets, can you advise why the short fund has not taken advantage of this decline and stayed with the S&P 500?
I regret not being short the emerging markets. It is probably the one positioning decision that caused me the most personal frustration, so let me try to explain the factors behind this decision. First of all, we had been losing money. My training discipline is that when I am losing money I turn risk-averse. If we had been making money I can assure you our accounts would have been short EM. More specifically, when my analysis signals a high-risk environment, I position defensively, and I am nothing if not disciplined about this.
I have done this long enough to know that positioning defensively basically guarantees missed opportunities. That is just the way it goes. I am willing to live with missed opportunities. What I don’t want are outsized losses. How do I avoid outsized losses? When I am in a defensive posture I avoid high beta, I avoid heavily shorted stocks in sectors, I avoid positions prone to abrupt changes in market sentiment. So to short the highly volatile and heavily shorted EM would have meant compromising my risk disciplines. Again, I will make some compromises when we gain performance momentum.
But there is another aspect to my investment process. When I am in a defensive posture, I am focused on providing a U.S. equities market hedge while keeping risk contained. In plain talk, it is providing a hedge without getting killed. EM does not provide much of a U.S. market hedge, especially when correlations get out of whack, as they did during the quarter. The bottom line is, it was a missed opportunity, but I try not to be too hard on myself. Focusing on the big picture defensive positioning was the right call during the quarter.
What is the firm’s estimate, by year, the arrival of mandatory digital currency in the United States?
I was hoping David would be able to answer this one. We’re having some technical phone issues, I guess here, so I will throw out my two cents. I can’t profess any insight, but my gut tells me there would be such an intense political backlash to mandatory digital currency, that that kind of proposal won’t happen any time soon.
What is your opinion on the potential for yuan devaluation as a response to Trump tariffs? How low do you think the Chinese stock market will go in the face of extreme Chinese debt and central bank debt write-offs in support of the Chinese stock market and currency?
A few questions there. It is really timely to think about China. I tend to believe Beijing is quite concerned with the risk of a currency crisis, of losing control of crisis dynamics. I think they fear capital flight and would prefer to avoid more Draconian capital controls. Over recent decades, basically every EM credit bubble ended with some degree of currency crisis. China would surely believe they have progressed to developed nation status, but I look at their institutions, their market traditions and policy measures and still see developing.
I have referred to China as the King of EM. This implies underlying fragilities. So I would think Beijing is willing to tolerate a modest devaluation. As we have seen over recent months, they are happy to send a warning to the Trump administration, but I expect they will be cautious going forward, wanting to avoid the risk of a sell-off attaining momentum.
For me, the big unknown here is, how much hot money has gone into capitalize on China’s higher yield credit. In the past I have referred to China’s currency regime as a currency peg on steroids. I believe three is huge carry trade type speculative leverage that has accumulated, especially in Chinese corporate bonds. And if this is the case, then the risk of a disorderly currency crisis is high. China’s bubble economy has become addicted to huge ongoing credit growth and I would argue that the quality of this credit continues to deteriorate.
So I believe systemic risk in Chinese (inaudible) _00:49:02_ continues to expand, and expand exponentially, as you see these huge amount of late-cycled debt, of rapidly deteriorating quality. So, for my framework, this is the kiss of death in terms of financial stability with a backdrop conducive for a crisis of confidence in their currency, and in their financial system more generally. So, I am very concerned. To what Beijing will intervene to support equity prices – who knows? You have the national team and all of that, but I see all of this as bearish for Chinese securities markets.
To what extent do you use or rely on technical indicators like the Dow-Jones Industrial Average, recently breaching its 200-day moving average?
I’m not a technician, but I always use a technical overlay, especially for risk management purposes. It had appeared that the market’s technical picture was turning bearish, as you wrote here. The Dow traded below its 200-day moving average for about a week. Even at the time this bearish indicator was not confirmed by most other indices. The S&P 500 traded below its 50-day moving average, but very briefly below its 100-day. Right now the S&P 500 has rallied above all its moving averages, but it has done so on waning momentum. So call me hopeful on technicals, but they are not yet signaling to me to be more opportunistic.
It looks like the global yield curve is about to invert. How much time do we have before we start seeing negative ramifications for the markets? What signs of market stress will show up first in the credit markets? Or is there another place to look first?
Yes, this is excellent. As I discussed in my presentation, I believe the flat yield curve is more of an indication of bubble fragility than as an indicator of U.S. recession. We are already seeing ramifications begin to materialize, as I believe the treasury bond rally fueled the major short squeeze and an ongoing period of excess in U.S. equities.
So I would not be surprised to see the U.S. stock market succumb to bearish global dynamics in the not-too-distant future, as you mentioned. I will have to closely monitor for impacts on U.S. credit, and typically, I would focus on high-yield credit spreads as the proverbial canary. But I have been keenly focused on investment-grade credit, corporate credit in particular. This could be the epicenter for some of the greatest excesses during the cycle.
As I mentioned in my presentation, Triple B corporate credits in particular, the riskiest investment-grade, is a good place to monitor closely. Investment-grade bonds have under-performed so far this year so this is supporting of thesis. I will also closely monitor credit default swap pricing for the big financials that have indicated a modest increase in systemic risk so far.
In the event of a severe correction or reversion to the mean in the stock markets, do you anticipate brokers defaulting in the event their clients can’t de-leverage quickly enough should there be an air pocket of no liquidity? I am just reminded of those who shorted the VIX in late January of this year, or the Swiss National Bank dropping its peg against the euro in January 2015.
I am of the view that the February blow-up, or the short (inaudible) _00:53:00_ strategies, is a warning of impending market liquidity issues. At this point, I will assume that in the event of a significant market break there will be client difficulties with margin calls and liquidations. In terms of potential market dislocation, though, my greater concern, again, would be with the derivatives universe.
There has been this proliferation of all kinds of derivative strategies, especially options trading. You see all the retail commercials on TV, and also, institutionally. There is a distinct possibility that an unwind of derivative exposures could prove quite disorderly. We saw a hint of this in February and previously, with these so-called flash crashes. As I discussed earlier, the recent short squeeze and this excess in U.S. markets has, at least in our view, significantly increased the risk of problematic illiquidity.
What do you suggest regarding primary residence with San Francisco Bay area housing markets and a large mortgage that went upside-down in the last downturn? It seems like it would be better renting.
Yes, and this is one of these unfortunate, and in many cases, terrible consequences of these bubbles because housing bubbles in San Francisco and elsewhere make life very difficult for so many. I think for a lot of people, selling at current prices and renting would make good financial sense, but there are usually other considerations and pressures to own. So it is tough for people to know what would be the best for them over the longer term. I certainly worry for those who must take out huge mortgages to afford starter homes in bubble markets. But for me, personally, I would prefer renting in those types of markets rather than buying, no question about that.
David: Let me ask one of these that I think was directed toward me:
On the Commentary you have talked about being prepared to shift from gold to stocks in that once-in-a-generation event when the Dow-to-gold ratio hits 3, or 2, or perhaps even 1-to-1 in ratio. In the interim, however, there is still time to buy and sell stocks. At the moment I think a lot of us are fearful of stocks, which is why we are tuned into the Commentary. What are some good indicators to keep an eye on to help us know when it is time to stop being fearful and start being greedy? The question references 2002. While 2002 and 2009 were not times to shift from gold to stocks on the basis of the Dow-gold ratio, they were nonetheless a good time to put some money into the stock bucket.
This is a big issue in terms of valuations, over-valuations, and what we have seen in terms of an unprecedented intervention in the stock market. Arguably, 2008/2009 we were marching on our way to a 3-to-1, 2-to-1, 1-to-1 ratio. We began to see huge intervention from the Fed when the ratio was at about 6-to-1, still above what would be considered the capitulation levels of previous bear markets. So we certainly were hesitant there in 2009 to shift out of gold and into stocks. As time would show, gold had another two to three years’ worth of growth and moved considerably higher, to $1900, and then with silver nearly $50 an ounce there in the 2011/2012 timeframe.
So, we would have missed a tremendous amount of upside on the metals side, and the ratio just didn’t tell you what you needed to know, didn’t tell you to move from one to the other. We do think we ultimately see a 3-to-1 ratio, perhaps even a 2-to-1 or a 1-to 1 ratio, and I would still argue that is your best time to be greedy. To the degree that you have a significant allocation of gold, you may begin reallocating at 5-to-1, 4-to-1, and 3-to-1, and not wait for what we saw in 1968, or 1929, 1982, some places where the ratio was very, very, very attractive – 3-to-1, 2-to-1, and 1-to-1.
There was also a question on platinum. Platinum is kind of an interesting asset. Relative to gold it sells at a discount, which is kind of odd today. I think there are some concerns in terms of its industrial use should we find ourselves in a global economic slowdown, the industrial demand for platinum is going to suffer. But by price, it appears that it has already suffered. It is kind of inexplicably cheaper than palladium, and inexplicably cheaper than gold. So you could look at it as a long-term value price catalyst as a secondary issue in terms of what would help it recover.
Doug, one question for you is:
If the Fed keeps printing money, and they may do so indefinitely, are you not a salmon swimming upstream?
Doug: (laughs) David, I chuckle because this question brings back memories. When I worked in Dallas with David Tice, on the wall in our conference room was the famous Thomas Mengelson (sp?) _00:59:58_ photograph of the bear about the chomp down on a salmon. We would often jokingly ask whether we were the bear or the salmon. I don’t think central bank money printing will ever provide a solution. It is actually a key part of the problem. So I don’t believe they will be able to fake their way out of debt problems, out of asset and market bubbles, out of economic maladjustment and global imbalances.
I don’t want to get too far in the weeds here, but I think there is a fundamental flaw in contemporary central bank doctrine. They believe there is a general price level that they can always manipulate higher through monetary inflation. As such, there is no need to worry about too much debt, too high asset prices, asset inflation or bubbles, because when necessary, the central bankers can raise the general price level to alleviate debt overhangs and asset over-valuation. Well, I’m sorry, but there is no functioning general price level. There are lots of different price dynamics within real economies and within asset markets.
And as we have witnessed, reflationary measures work to inflate asset prices and stoke speculative excess, leaving consumer prices pretty much in the dust. So my view is, activist central banking and inflationism generally, is deeply flawed and dangerous. These efforts to inflate out of bubble issues basically only worsens bubble risk, and that is financially, economically, socially, and geopolitically.
David: Next question relates to something I mentioned on the McAlvany Weekly podcast this week:
At the end of the weekly podcast you claimed to know exactly when the global credit reserves would run out, but you didn’t say when that was. I figure 6 trillion dollars in global reserves divided by 60 billion, for a one-month reserve draw-down, averaging up a few billion dollars, means the reserves will deplete in approximately 100 months. I would have thought much sooner than that. What approximate date did you come up with, and how did you calculate it?
First, I think it is worth noting that the 6-trillion figure is total global reserves. Second, I think it is worth noting that China is half of that. Their remaining foreign currency reserves are 3 trillion dollars. They spent roughly 900 billion maintaining stability with the RMB here in recent years. And I think it is also worth noting that of the remaining 3 trillion, that is divided up amongst a lot of different countries. So you are talking about certainly one fuse, if you’re thinking about 6 trillion as a cumulative number, but each country has its own issues.
So when Doug was mentioning earlier what we were seeing with the real in Brazil shrinking by 15%, or the South African rand and the Turkish lira shrinking by 14%, the Argentine peso collapsing by 30%, if you dig into any of those countries you will find that their foreign currency reserves are dwindling, and you do begin to see capital flight and real pressure on their currencies. So I would say, of the 6 trillion, the Chinese have the longest views, but they also have so much in terms of debt layered into their system, both know debts and then the dark market debts which are into the trillions, as well.
What we are looking at, really, is the fragility in any one of those peripheral countries which can be destabilizing globally. You can just go through the litany of financial crises of the last 20 years and they started someplace, and then migrated lots of other places. Could it be China? Sure. Do they have a little longer fuse? Yes. Could it be Turkey? Sure. You look in the case of Turkey and very interestingly, they have a ton of foreign-denominated debt that is held by Italian banks, held by French banks, and held by German banks.
So very quickly, reserves dwindling in Turkey can show up as a significant issue in terms of a markdown balance sheet – markdown – in places like Germany. And right there in the middle of Europe. So that is how it moves, I think, fairly quickly. But do I know the exact date? No, but I think we know that the fuse is lit.
Doug, we have a couple of more questions here, but also if you have any comments on that reserve issue.
Doug: The reserve issue – right now the market believes that there are adequate reserves in China and elsewhere. And that holds until all of a sudden there is a month or two where the reserves drop significantly, rapidly, and then market perceptions change quickly, and then you can have this aggressive move to the exits where reserves are depleted very, very rapidly. So I think there is way too much complacency out there on these reserve boards in China and throughout the emerging markets.
David: This is question on allocations:
Any new insights on the percentage of assets you would have of your savings in a variety of assets, whether it is silver and gold, precious metals, or real estate and land, stocks, cash, alternative investments?
The difficulty with this question is, I would say – and Doug, feel free to interject here – I can state something that is either personal position or generally a balanced position, not necessarily going to be a perfect fit for the individual investor with particular objectives or risk tolerances. But if I was having a back-of-the-napkin conversation with the next generation, to kind of put in perspective how you save, how you grow, and how you should allocate, I think you would do well with not more than about 20-25% in real estate and 20-25% in stocks. You could have 20-25% in cash, and precious metals also, and alternative investments 20-25%. If you add up all those 25%’s you have more than 100%. I think you take circumstances and either de-risk a portfolio, create more of a hedge, and tinker.
But the Tactical Short fits in that alternative investment category as a ride-along next to an equity portfolio, to eliminate some of the long-term volatility in an equity position, and also to enable the creation of cash in a market downturn. We are hoping that our investors in Tactical Short have liquidity when liquidity actually gives you a leveraged purchasing power, taking that liquidity and buying other assets that may be less expensive.
Anything you want to add to that, Doug?
Doug: No, that was very well said, David.
David: We are about through our questions. There is a question about hyper-inflation and we have one live right now in Venezuela. Is there an imaginable circumstance where you could have hyper-inflation like we have in Venezuela, currently 43,000% annualized right now, and rising, where that becomes a global issue, a worldwide issue?
Doug: Yes, I think it is a possibility, although I don’t see it on the horizon. What we are seeing now is these individual country episodes of inflation leading to hyper-inflation, and I think we will see more of that now that we have currency issues throughout EM, capital flight issues, and all the negative consequences that go with those dynamics.
I worry about the central bank response to the next crisis, and how carried away that gets. There is a scenario where they are flooding the world with electronic dollar currency balances and things get out of hand. So down the road that is a possibility, but I think we will have plenty of time, and I am hoping we have, to prepare for that.
David: We are bound to have stirred some questions, and if there are things that we have not addressed in our comments today or the Q&A today, I will be circling back around with those of you who have been on the call, and would love to have a conversation with you further about what we are doing, what you are doing, and how we may be able to compliment that.
These are pretty interesting times for us in the wealth management business. The idea of record complacency, what I mentioned at the beginning of the conversation today – 668 billion dollars in margin debt – you are seeing complacency and the kinds of behaviors which were symptomatic of the market peaks in the 1990-2000 timeframe, in the 2006-2007 timeframe, and we are there already.
There is some degree of frustration in being able to pinpoint the timeframe for ramifications stemming from excess, but I think what we have concluded, just as Doug described, what we do is a wise hedge. There is a degree of wisdom which is anticipatory, and you see the signs of the times, you see what is happening in these various areas, and then make strategic investment allocations.
I would like to continue the conversation with you directly, and I look forward to, again, any other questions that we might have missed, or stirred, in the midst of this conversation. In the next week to ten days we will be reaching out and would love to carry on the conversation one on one.
Thank you for joining us for the call today, Q2 McAlvany Wealth Management Tactical Short Conference Call July 19th. We wish you well. We want you to be well and do well, and if we are a part of that equation, it would be an honor and a privilege to partner with you. That’s it for the Q2 Conference Call today. Take care.
Doug: Thanks everyone. Good luck out there.