David: Once again I want to welcome you to the McAlvany Wealth Management Tactical Short First Quarter Conference Call. This is David McAlvany and I’m here today with Doug Noland to look at the market backdrop, and also the direction Tactical Short has taken last quarter and as we anticipate coming into this next quarter. So today we will begin with an overview of the financial market backdrop. That will be Doug’s responsibility, primarily, and as the portfolio manager for the Tactical Short, Doug will look at both current and anticipated market exposures. Then we will move to the Q&A.
Of course, throughout the time that we have today we will be monitoring the chat box at mwealth.wpengine.com. If you go to that main page you should see a chat box at the very bottom of the page. If you initiate that you can submit followup questions and we will be addressing as many of the questions as is reasonable in the timeframe given that we have quite a few questions to go through already that you have submitted, and we will take those as quickly as we can. There are two categories of questions, those pertaining specifically to the Tactical Short, and then some that are more general to the broader markets or specific markets, whether it is gold, silver, the bond market, emerging market equities, the debt market, what have you. So we will focus on the Tactical Short questions first, and then come back to the other ones as time permits.
Just to get us started I thought I would take a walk down memory lane. If you will, a travel back with me to January 7th, 1973. Alan Greenspan was quoted as saying it is very rare that you can be unqualifiedly bullish as you can now. For those, again, with some perspective in the markets and history, 1973 and 1974 ended up being one of the most grueling bear markets ever, and it is interesting that when you get a group of Ph.D.’s and market practitioners together and euphoria has been whipped up, what they see is what they see.
So again, Greenspan’s quote, it’s very rare that you can be as unqualifiedly bullish as you can today. I think that is helpful for framing what we have in the midst of what appears to be a market melt-up today. Liquidity continues to flow. We have a bubble, you could say, in almost everything, but more accurately, you should say we have a bubble in capital in large part because the cost of capital, globally, has been crushed, and as capital costs have come down it is really no surprise that asset prices have gone up.
And so, with lower cost of capital you see increased risk-taking. Some of that is by necessity as people search for yield, and some of it, of course, is just distortions in the asset markets everywhere because our reference point, again, that cost of capital, has been played with. I think that the clearest demonstration of that is looking today at Greek treasuries maturing in 2019, credit rating of Caa2, not exactly top of the heap in terms of credit quality, and of course, the Greeks, as you know, have had several years of tough goings on. But the yield on that paper is 1.44%, and 144 basis points, compare the same kind of maturities here in the U.S. market at 1.75 to 1.95, and you just have to say that this isn’t normal. It’s not healthy. And ultimately, we would argue it is not sustainable.
Of course, we know that the ECB has participated in distorting the cost of capital in Europe, but the follow-on to that is that when you distort that metric it has a knock-on effect into so many other asset classes and categories. So the question of sustainability there, I think, is one that Doug will get to, and without further ado, I want to bring on my teammate, Doug Noland, who will give us a little bit more of the financial market backdrop and address specific things that he saw pertaining to the Tactical Short for the last quarter, and in anticipation of the next. Thanks, Doug.
Doug: Thank you, David. And thanks, everyone, for jumping on this afternoon’s call. And a special thanks to our account holders. We very much value the relationships we are developing. I also know there are new listeners that have called in to learn more about Tactical Short. We have detailed information available at mwealth.wpengine.com/Tactical Short.
But let me begin with a brief overview. Our objective for Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s overall investment portfolio while providing downside protection in what we view as an especially uncertain and high-risk global backdrop. We short securities, we will short stocks, ETFs. We will also buy liquid listed put options and shorting comes with risk. We tactically vary exposure, but expect to generally be between 50% and 100% short. Because of the unfavorable backdrop our maximum short exposure in 2017 was 35%.
Today’s targeted short exposure is 18%. This strategy is designed for separately managed accounts, or SMA. We see Tactical Short as an integral component, let’s say a 5% to perhaps 20% allocation in a well-diversified investment portfolio. This is important. We’re definitely not recommending any big bearish bets against the market. We do, however, believe that it is time to refocus attention to risk and risk management.
While we anticipate there will be environments where we are more aggressively seeking outsized returns, this strategy will generally endeavor to have less volatility and lower portfolio beta than the U.S. equities market. I have been managing short exposure going back to 1990. A Tactical Short is unique in the marketplace. We believe we have structured a better mousetrap than other hedging products available in the marketplace. David, would you like to jump in?
David: Yes. Just looking at the backdrop, and looking at 2017 as a very extraordinary year, one of the things that is worthy of note is a lack of market volatility, unless you’re counting upside volatility. But that is measured a number of different ways. If you’re looking for a psychological measure, or a fear gauge for how people anticipate the future volatility, you can look at the VIX, and we saw that recently hit 8.96. Single digits are pretty rare for the VIX, and again, measuring puts and calls and the volume into those, haven’t seen as low of a number since 1991. That is along with a number of other things – institutional managers holding record low levels of cash relative to equities in the their portfolios, seeing the number of bullish investment advisors as the greatest in 30-40 years.
It is interesting, because retail investors and institutional investors are running at the same pace and in the same direction, again, looking at the high, high allocations, percentage allocations to stocks relative to cash. In fact, it is about the greatest on record going back to 2000, according to the American Association of Institutional Investors. So equity speculators, if you all listen to our weekly Commentary with any regularity, you know we track the borrowed money that is going into equities as a percentage of stock market capitalization, and in nominal terms, of course, has never been higher, stretching toward 600 billion. Pretty significant when you consider the sell-by date and nature of margin debt, it has to be paid back, so better than half a trillion dollars, or some percentage thereof, will have to be let go on the other side of the market tipping, as and when it does.
Positive market returns for all of the last 12 months of this year is highly unusual, and I think it is important to know that the rate of change is gradually increasing, which to us is a tell-tale of getting to the end of the cycle where things get bid up much more quickly. Again, the uniformity across sectors and geographies is also telling. When you think of the Austrian market being up 47% last year, the Greek stock exchange, the Athens Exchange, up 41%, Argentina 49%, Chile up 44%, Vietnam 45%, South Korea in spite of tensions just north of there up 34%. I can go on and on. Really, the only big loser in 2017 was the Pakistani stock market, down by about a quarter at 22%.
All that to say, it is highly unusual to see the consistency month after month, and again, the uniformity across sectors and geographies, and it really says that there is not a lot of distinctions being made when it comes to valuing one asset versus the other, which is, again, characteristic of there being too much liquidity in the market. So Doug, do you want to pick it up from there?
Doug: Yes, the lack of volatility is definitely a global phenomenon. It is worth noting that the global MSCI Equities Index has gone a record 19 months without a 5% pullback. I also wanted to quickly mention ETF flows – 51 billion in December for 476 billion positive flows in the ETF complex in 2017, up 66% from record 2016 flows. So the bottom line is, it was an unfavorable year on the short side. Markets boomed in the face of Washington political drama and all the uncertainties, heightened geopolitical risks, and Fed rate increases. It is easy to forget that there continue to be major financial fragilities around the globe – a bubble in U.S. securities markets, a historic credit bubble in China, a bubble in European debt markets and a bubble in emerging markets.
Yet this ongoing financial fragility ensured another 2.7 trillion of global QE in 2017, liquidity that stoked the global bubble to precarious extremes. Global liquidity flowed in abundance into U.S. securities markets. I had held the view that there was a reasonable probability for a tightening of financial conditions in 2017. Instead of a tightening, conditions only loosened globally and in the U.S. The bullish liquidity dynamic for 2017 has continued daily as we start 2018. But to have such extremely loose finance at this stage of a cycle is dangerous. I would say it’s reckless. And there will be quite unfavorable consequences. At this point, the longer the melt-up, the more dire the consequences.
Let me spend a couple of minutes discussing Tactical Short exposure for the quarter. I think in most calls going forward this will be a longer segment of the call. We began the quarter with short exposure at 28% and that was 21%, basically just short the S&P through the spider ETF, 5% in the mid-caps, 2%, a very small position in the NDX. We had reduced this to 20% by October 20th. We then reversed course and increased exposure to 36% by November 17th. Why did we do this? There were indications for a possible tightening of financial conditions.
I’ll just go through a few of the indicators that we were following at the time. We had a widening of corporate credit spreads, and that was junk and investment grade. We had a significant break in the junk bond market at the periphery, something we watch closely, heavy outflows. There were difficulties in Washington, crafting tax legislation, especially with the corporate tax cuts in the Senate. There was a rise in treasury yields. This combination of rising treasury yields and widening spreads is an important indicator in my analytical framework. We also had heightened currency market volatility at the time which increased the potential for risk off. We had a narrowing of equity market leadership and broader market under-performance. In short, the risk and reward for shorting appeared to be improving.
Well, we reversed course. We began reducing exposure on November 21st. The market was turning more constructive on passing the tax legislation. Financial conditions were loosening. We ended the year 22% short and that was predominantly the S&P, ETF. We are currently at 18% short. We have no stocks or puts short today. We have had none since the inception of the fund back on April 7th. The risk of shorting individual company stocks has remained too high, and I continue to wait patiently for good opportunities to purchase put options.
We structured Tactical Short to ensure we had the flexibility to get through a difficult market environment. I have often said that being 100% short all the time, as many of the short products in the marketplace are structured – that is risk indifference. Risk indifference on the short side doesn’t work. Tactical Short accounts after fees lost 1.93% during the 4th quarter. That’s 1.93%. I always compare performance relative to the S&P 500, so the Tactical Short’s 1.93% loss for the quarter was 29% of the inverse of the S&Ps 6.65% return. Since inception, Tactical Short has declined 3.43% while the S&P 500 returned 15.0%.
I will just quickly highlight some of the performance of our closest actively managed short competitors.
David: Doug, if I might interject on that, I want to point out that the difference between an actively managed fund and in being short all the time, is that you do get to get out of the way. We have seen all the dynamics and although we are looking for cracks in the marketplace, and indications and reasons, according to your mosaic, to be getting shorter in the portfolios, we are committed, with a certain level of faith, that that is going to happen. And if the indicators change, so does the positioning. Your last statistic, I think, is compelling, that the S&P 500 in that same timeframe is up 22.8%, and we basically just said, “No, we don’t have to get in the way of a steamroller.” As and when the market conditions are favorable, we will absolutely get to 100% short, but until that point, it is not a question of seeing what kind of pain we can all suffer through. You’re doing this in a very intelligent fashion. I just wanted to interject.
Doug: Thank you. Yes, we’re trying to provide a wise hedge. Just to quickly note, the competitor performance, the Grizzly Short Fund was down 5.96% during the 4th quarter. The Ranger Equity Bear was down 6.78%. The Federated Prudent Bear was down 4.06%. And even the proshares, the 100% short – that was down over 6% during the quarter.
There is another way to look at this relative performance. Compared to the S&P 500, one of our closest competitors lost more than the S&P 500 return, one lost 90% of the S&P’s return, one lost 61% of the return. And again, our number was down in the upper 20s. I hate losses, and of course, in hindsight, I wish we could have lost less. But looking at things objectively, we have managed risk diligently and we’re getting through an extraordinarily challenging environment on the short side – just really tough. Importantly, the 4th quarter, and for all of 2017, the environment strongly confirmed our belief that the most critical factors when managing short exposure are to manage the overall exposure, to manage portfolio beta, and the composition of short exposure. It’s not a coincidence in the speculative environment, our competitor closely associated with shorting, fundamentally weak companies perform the worst in that environment. That’s not a surprise to me.
One can question why we didn’t reduce exposure to zero. Fair question. First of all, I believe the downside risk today in the marketplace is extreme. I look at the market backdrop and see unprecedented risk. I see history’s greatest bubble, along with escalating political and geopolitical risks we are going to address briefly. There is high risk of being fully short, no doubt about that, and that explains why we have maintained limited short exposure, but we believe the risk of being in the market is also extreme, and our objective is to offer a sound hedging instrument. I don’t believe it is the time to go un-hedged. We are striving to provide a wide hedge in an extreme marketplace.
To me, the backdrop is reminiscent of other major market tops. 1987, 1999, 2007 come to mind. There are disturbing similarities to 1929. As always, things look great at the top. Booming markets are at all-time highs, economic activity is strong. Corporate earnings and cash flows are robust. Bullish sentiment is at extreme levels. I accept that is all factual. But there is a major issue that goes unrecognized in all the exuberance. The underlying finance fueling the boom is unsound, and becoming more so by the week, especially during a late cycle speculative melt-up, which is at its core a manifestation of unsustainable monetary disorder. There is way too much money sloshing around the system.
Ben Bernanke has argued that if the fed had just created 4 billion and recapitalized the banking system after the 1929 crash we could have avoided the Great Depression. But the paramount issue was not the amount of money necessary to keep the banks solvent. The over-arching issue was how much ongoing credit was necessary to keep a highly mal-adjusted economy aloft, and to sustain rapidly inflating securities and asset prices. At the end of the long cycle the amount of credit to sustain the bubble becomes huge and increasingly unmanageable, and that is where we are today.
Late in the cycle, systemic risk rises exponentially. The quantity of new credit grows briskly while the quality deteriorates rapidly. Markets become manic and detached from reality. Fundamentals, such as earnings, become inflated during the bubble, and are then extrapolated far into the future. Things look great so long as you feed the beast with ever more quantities of money and credit and speculative excess. Meanwhile, financial and economic systems become increasingly vulnerable to any pull-back in credit and risk-taking. Market melt-ups greatly exacerbate this vulnerability, creating unappreciated fragilities. That is where we think we are today.
Speculative leveraging creates self-reinforcing liquidity abundance, liquidity flows through the asset markets, and into the real economy, distorting prices, distorting decision-making, distorting investment, and distorting economic structure. The longer this continues, the deeper the distortion, the deeper structural impairment, and the greater the amount of speculative leverage. There becomes heightened systemic vulnerability to a self-reinforcing reversal in asset prices, and a collapse in speculative leverage.
I mentioned last year’s 2.7 trillion growth in central bank credit. In addition, there was record total Chinese credit growth approaching 4 trillion dollars, much greater than we had even during the mortgage finance bubble period. Perceptions are that central banks have everything under control, that Chinese officials have everything under control, but this epic market misperception promotes the type of risk-taking and leveraging that ensures bubble excess and an inevitable crisis of confidence. It is stunning how little we have learned from the past three decades.
The title of this call is Bubbles, Bear Markets, and the Triggers for Melt-Ups and Melt-Downs. I have often written over the years, and never is it truer, that bubbles go to unimaginable extremes, and then they double. Excess begets excess. So we will start with some triggers for melt-up. We’re in one now. Markets obviously have a strong inflationary bias. They’re highly speculative. So as long as financial conditions remain extremely loose, there is a risk that things could turn even crazier.
Central bankers could remain timid. I expect them to be more aggressive and more toward normalization, but right now the Bank of Japan could continue with massive QE operations, the ECB could delay winding down their QE this year. The Fed could stay the course with this cautious baby-step rate increase strategy that only feeds these financial conditions. Perhaps China doesn’t slow credit. Chinese officials would prefer slower credit growth, but are they willing to take the risk of bursting their bubble? With risks so high, and rising, markets presume no meaningful Chinese tightening.
Market structure is also a trigger for melt-up. We have a very unique market structure today. We could have a derivatives-related market melt-up. There is a proliferation of option strategies. On an upside breakout, those on the wrong side of call options are forced to hedge exposure by buying into the indexes, yet manic call buying can provide market rocket fuel. I’ve seen that in the past, and it certainly seems to be in play today. A derivative dislocation and melt-up in the big NASDAQ stocks was fundamental to the market top back in the 1st quarter of the year 2000.
We also have the ETF complex that didn’t even exist back in 2000. That complex is up to 3.4 trillion and rising rapidly. There has never been such a convenient mechanism for the public to fuel and melt-up. We have to be aware of this. There is also the 3 trillion dollar hedge fund industry and the proliferation of leveraged trend-following strategies. We are mindful of all these mechanisms that are capable of fueling further historic speculative excess.
Potential triggers for melt-down: First of all, it could be exhaustion. Manic behavior is not easily sustained. I tend to view the parabolic speculative blow-off as the beginning of the end of the bubble. I don’t know how long they last, but it’s a signal that you are very late in the game.
Part of the potential trigger is rising rates. We had ten-year yields close today at 2.62%, the high going back to 2014. I consider global fixed income the greatest market bubble of all time. People are way too complacent. There is enormous leverage that has accumulated after years of excessively low interest rates. I believe there is greater risk of a bond unwind after these strong early year ETF flows subside. I believe government bonds are grossly mispriced on a global basis. In particular, the Japanese and European debt markets are an accident in the making.
It is my view that enormous leverage has built up in the U.S. corporate debt market, especially through structured credit products and other derivatives. Central bank tightening measures this year could easily prove a trigger for market trouble. We have rising inflation risk. I think the global economy is more over-heated than generally recognized. Central banks have waited way too long to begin normalizing the rate backdrop and now there is a steep price to pay for the resulting monetary disorder. There is also rising government debt issuance, notably here in the U.S. in the face of waning central bank support.
We are also seeing heightened currency market instability. These are enormous markets, these currency markets, and oftentimes this is where a crisis begins, with their huge carry trade speculative leverage strategies in the marketplace and other embedded derivative leverage in currencies. This is at the top of the list of where the central bankers could lose control, and this loss of control could quickly trigger a change in market sentiment and market tumult.
Market structure, which is a key theme of mine for 2018: You have this short volatility, which is essentially writing market flood insurance during a drought – an unwind of this huge, crowded trade could send the cost of market insurance much higher, with potentially huge ramifications for risk-taking and market liquidity. You have this ETF issue and the perception of safety and liquidity. Send your money into an ETF – buy and index. I call it moneyness. There is that belief that you can always get out, and your investment is always protected. This is at the heart of market misperceptions of risk, that essentially become a massive speculation of market direction. We’ll see how it works when the markets reverse.
Let’s not forget the hedge funds. They don’t get as much publicity as before, but the hedge fund industry, as a whole, has been forced to boost long exposure, and significantly slash shorts. I think there are also big players in the short volatility game. In a significant market reversal the hedge funds will move quickly to cut longs, boost shorts, unwind derivative positions, and likely try to purchase market protection. This has the potential to abruptly and profoundly alter the market liquidity backdrop.
Markets these days are convinced that central bankers will work together to ensure markets remain liquid, and immune to meaningful pull-backs. But there will come a time, a point where individual interests diverge within the central banker community. I think we are starting to see some of this with dollar weakness. So far this dynamic has pressured foreign central bankers to delay rate normalization and markets have interpreted this bullishly. But this could change. This could evolve to where central bankers pressure the Fed to boost rates more quickly to support the dollar. David, I’ll send it back to you.
David: What we are talking about is triggers for a potential melt-down. We covered those for a potential melt-up. I think what you started out by laying out is the groundwork for an environment of instability. I sat with a class of 5th graders a few weeks ago and explained a mountain climbing trip that I took many years ago up Mt. Rainier. With two days of constant snow and wind the backdrop was absolutely unstable, and avalanche danger was everywhere. So, it actually doesn’t matter when you are in an environment of instability what the trigger is. As you suggested a moment ago, when we talk about a market reaching a point of exhaustion, it can be just that. It doesn’t have to be anything external. Just the internal weaknesses can reveal themselves.
So picking a trigger is actually less important, but I do think it is important to look at as many as possible to know where it might come from. And certainly the realms of politics and geopolitics represent places where you might see other potential triggers for the environment which is already unstable. And I think to start with the White House is one place that you can say that we see political dysfunction, we see an unhealthy relationship to the House and the Senate. There are some very productive things being done by the White House that are absolutely hated. We still see, for 2017, 90% of the press that covered Trump’s activities was negative – again, just looking for places where there might be instabilities and triggers.
Trade policy is something that is not settled. Will be coming out of NAFTA? What does the new policy look like? Is it better for us? Is it worse for us? How does it affect our trade partners? Oftentimes when you are dealing with trade policy, you end up solving one problem and creating three or five other problems. And so trade policy is a classic environment where you can have unintended consequences and in the day that you are taking your laps and collecting your laurel wreath and you’ve won, actually, you set in motion something that is very unhealthy and damaging to the market.
There are also the trade policies with China which are a significant issue. That is something to keep in mind. The language between the U.S. and China is certainly less than ideal, with this last week there even being a suggestion of liquidation of treasuries, reduction of treasuries, with some consequences into the U.S. currency and debt markets.
We have the mid-terms. We are kind of shifting now toward mid-term elections, and if things do not change from an economic or market standpoint, you know that Democrats can’t run on the economic theme. So what will they be digging for? We’ll have to wait and see.
Geopolitics, again, is another area. If we have some degree of political dysfunction geopolitically, clearly we have a quagmire in the Middle East. There continues to be issues with Iran, stability issues within the royal family in Saudi Arabia, and certainly nothing is settled with our sanctions still in place with Russia. We continue to use the Treasury Department as our way of enforcing a whole host of carrot and stick initiatives globally. That is not generally appreciated in Europe. It is not generally appreciated by anyone who is at the end of the stick.
North Korea – what does that become in 2018? Time will tell. Given the pricing in the KOSPI, the South Korean stock market, there is not a lot of market concern about something happening with North Korea, but again, these are all potential triggers to keep in mind.
Doug: Thanks, David. I would just add, from my standpoint, on the geopolitical, bubbles, at their core, are about wealth redistribution and destruction. And with this being a global bubble of unprecedented proportions, I worry a lot about the geopolitical ramifications when this bubble bursts. Odds are not low that a geopolitical development becomes an important market trigger. I have been managing short exposure for a while. I have persevered through numerous market bubbles and melt-ups, and I have the gray hair to prove it. These experiences shape how I approach managing money. They certainly shape how we are structuring Tactical Short and how we are positioned today.
I refuse to fight the market. I’m not actively trading – I have not been looking for opportunities. I’ll be opportunistic when the market backdrop changes. That is fundamental to what we do. We’re not going to go out and pound our heads against the wall. I admit to being frustrated. I hate to lose money, it’s somewhat tiring coming in day after day, staying intensely focused, but disciplined and patient. Clearly, it’s no fun managing a short product in this type of market backdrop.
Most importantly, however, I’m not getting beat up here, analytically, financially, or emotionally. Short sellers in this type of a very long bullish cycle become punch drunk, virtually despondent. I’ve been there – I’ve lived it. It’s absolutely miserable. But I can tell you, I am not miserable today, not in the least. I’m excited and I would imagine I’m probably about the only excited bear around right now. I’m excited about the unfolding opportunity. I feel we have trained our careers for this unfolding opportunity. We have kept losses limited and we have avoided the emotional pain. So I’m ready. I’m ready to go. We just need some cooperation from the market environment.
I think it’s coming. I don’t think the current market euphoria is sustainable. I believe financial conditions will tighten this year. So at this point, the higher the market melt-up, the greater the excess, and the greater the opportunity. I see overwhelming support for my global bubble thesis. For a while now I’ve called it the Global Finance Bubble. It has gone to the heart of money and credit, it’s gone global, it’s gone across all asset classes and I’ve seen all the confirmation I could ever expect. The finance fueling this extraordinary global boom isn’t sound – I’m clear about that – and I believe it is highly unstable. My job is not to predict the market, but instead, to be prepared to react to changes in the financial and market backdrop, along with changes in the risk/reward for shorting. I am convinced it is going to be a most exciting 2018 – a really exciting 2018. David, back to you for some Q&A. Thanks, everyone.
David: For those of you who know Lenin’s famous quote, “Worse is better,” that might be the case for us in 2018, and I can’t help but think of the dry spell that Churchill went through from 1952 to 1963 when he had been sort of put out to pasture – no one really cared about him. But he was the man for the hour when the crown ultimately called him in to be Prime Minister. Obviously, you’re not in politics, Doug, but I do think that there is a unique set of characters required for each episode or chapter in history, and I agree with you – you have been training your entire life for this particular chapter in financial history, and it is one of the reasons why we are incredibly excited about being in the wealth management business, with a very unique product offering through the Tactical Short, and you may, in fact, be the only bear alive today. So you’re not entirely extinct. If anything happens to you I think we will know that we have lost a species.
We want to dive into the Q&A, and I’m going to start with one that deals with composition of the portfolio. I’ll go through as many of these questions as possible. Some of these questions I will answer directly, and many I will pass along to you, Doug. This is how the question reads:
I assume that the capital that is held in the Tactical Short account is held in bonds or cash at the brokerage. If bonds are used, is there any strategy in use to protect against a drop in the value of the bonds? Please comment on the risk to capital, depending on which asset class it is held in.
Doug: Excellent question. Other short products will invest the cash inflows from investors into third-party derivatives. They will go out and reach for yield. They will do whatever they can to use those cash reserves to boost performance. I don’t take risk with those cash reserves. When an investor sends money in to Tactical Short, it is in cash, we do not buy bonds with it so we don’t have any bond risk, and we will also buy treasury bills with that cash. It does not take cash to short stocks. We sit on a huge amount of liquidity, and we protect that liquidity. We do not take risks with it.
David: The next question is on counter-party risk. It reads:
To what extent does investment in the Tactical Short product represent risks tied to the financial health of the offering firm? Just like investments with a large bank. Just like, for instance, Wells Fargo represents risk related to its derivative exposure, what risks are the firm holding, or is the Tactical Short product exposed to?
Doug: Another excellent question. These are issues I have had to think about throughout my career and we take all of these very seriously. First of all, we are structuring this so there is total transparency in our individually managed accounts. Anyone can get online and see all the trades. They can see the positions. This is not some hedge fund where you have to wonder where your money has gone. You’ll see where it is. We would not domicile accounts at a broker that we believe had potentially problematic exposure to derivatives or proprietary trading.
Again, I have thought about systemic risk for literally decades now, so all of this we manage knowing systemic risk is in the future, and we need to protect investors and manage around it. We take counter-party risk very seriously, as I have throughout my career. We avoid third-party derivatives and other such exposures. We do hold cash at the brokerage, but we can easily purchase treasury bills, and I have done this throughout my career. It is an excellent question and this is something near and dear to our hearts and why we structure Tactical Short the way we do.
David: The next question deals with portfolio construction, and reads:
Within the Tactical Short product, what diversification is represented in terms of market sector risk?
Doug: Yes, another good question. Diversification is always important, especially on the short side. Big short bets with individual stocks or sectors can lead to surprisingly big losses. I know there is a well-known bearish hedge fund – they lost 50% in 2016, came back and lost another 20% in 2017. We’re not doing any of that. They must have been short a group of stocks that became highly correlated in a short squeeze environment. We manage around that type of thing.
We take a much different approach. We do not take large positions in individual stocks, and we won’t excessively over-weight particular sectors. We will take sector positions, but I have stated that I won’t over-weight a particular sector more than 10 percentage points above the sector weighting in the S&P 500 index. And a lot of times, if I want to take a significant sector over-weight, I will at least partially use put options where I can play that over-exposure with a cap on my potential losses.
David: This is a complementary question:
Do elements of the Tactical Short product have more risk when it comes to probable or possible government responses to a major market downturn?
Doug: I guess this is another area where I’ve lived through enough government policy responses to know I have to manage around them, especially in the marketplace. Anytime you see stress in the marketplace, I immediately start to focus on potential policy responses. That will always be an important part of my analytical process. What the likely government response will be – the timing is all key. Actually, this is an important reason why experienced active management is critical on the short side, and why we believe we have a different and superior approach than other hedging products in the marketplace. You can’t manage short exposure without being keenly focused on policy-making – macro-analysis.
David: This one may time into a question of timing, if you will:
At what indicators is Doug looking at to asses if the melt-up is exhausting itself?
Doug: That is another good question. I have a mosaic of indicators, lots of indicators. There is science involved here, but there is an art, because part of what I have to do is weigh which indicators are the most relevant during a particular period. My focus is not so much to identify market exhaustion but to gauge financial conditions. That is the key here. Is risk and leverage being embraced, or is risk-aversion starting to seep into the marketplace? That makes a huge difference how I’m looking at things. Most specific to the stock market, I will, of course, closely monitor fund flows. That is key. Where is money going? I want to follow sentiment very closely.
Market technicals – I’m not a technician. While I’m an amateur technician, I have a close relationship with a professional technician that I rely on. I want to know the breadth of the marketplace. But my focus is generally less on the stock market, and more on overall financial conditions, so I’m watching various interest rates, credit spreads, mosaic of risk premiums, close focus on hedge funds, trading strategies. Hedge funds are the marginal source of liquidity in the marketplace? I want to know what they are doing in regard to leverage. The derivative markets is another marginal source of trading liquidity in the marketplace. The currencies are key and there is a lot of leverage speculation in currencies. Those types of things are an important part of the mosaic.
I have witnessed enough bubbles and crashes over the past years to appreciate how quickly the liquidity backdrop can change. I believe there is unprecedented speculative leverage today that has inflated the asset markets here in the U.S., in Europe, China, Japan, and the emerging markets. On and off for three decades we have been told that deflation is the greatest risk. I have always believed that market bubbles are the greatest risk, and that is the way I look at the market today, and that is the focus on these indicators, because the bubble either inflates, or the bubble is in trouble. So that is the focus.
David: This from an online participant:
What sectors do you expect will be the weakest and start the decline ahead of overall market corrections?
Doug: Right. Generally, I focus a lot on the periphery versus core analysis. So anytime, or generally, when you have some risk aversion seep into the marketplace, you will see that first. You will see the initial indications at the periphery. So that is why we will be following junk bond performance flows carefully. We are already seeing some encouraging signs. We certainly follow the small caps closely. But a lot of it just depends on how this unfolds. Does it unfold with a surge in market yields? Does it unfold with years of central bank tightening? Do we start to see more concerns with inflation? Do we start to see the hedge funds?
All of a sudden, if you get a particular environment where the hedge funds are unwinding trades, then the stocks that they are long are important indicators, the stocks they are short are important indicators. How they are positioned is important. So there are a lot of different areas, and I try not to think too far ahead here. I have my own hunches as far as how this will unfold, but I’m looking for initial signs of weakness to help drive my sector positioning.
David: The next question deals with a market-driven interest rate spike. It reads:
Can you foresee a situation where, market-driven, as opposed to the Fed setting the rates, interest rates could rise significantly in a short period of time, not due to general inflationary pressures, but due to a “cash crunch,” a shortage of electronic U.S. dollars in various financial institutions in the financial and banking system?
Doug: Absolutely. I remember 1994 clearly. The Fed raised 25 basis points and the wheels almost came off in the bond market. We had yields rise 250 basis points, and the Fed, in that environment, didn’t know what to do. They were saying, “Okay, is the market is signaling we need to tighten more quickly?” It really confused central bankers. Since that experience, central banks have erred on the side of raising rates very cautiously and the markets know that. That is one of the reasons why last year, in the face of the Fed raising rates, ten-year yields actually declined slightly.
I think all of this changes if the markets fear that the Fed is going to be forced into increasing the rate of its tightening, that they may actually impose a real normalization of policy-making. I know last year, at times, the market would think, “Maybe one more rate increase.” All of a sudden, it wouldn’t take much for the market to say, “Wait a minute, the Fed could easily go another 200 basis points.” And once the market starts to think in those terms, I think that changes the game for bonds. I think that is when we start to see more hedging, more de-risking, more de-leveraging, and that is when it really will be outside of the control of central bankers. And for me, that is when, analytically, it will get very interesting.
David: Could that issue alone – just to continue on that last question – could that issue alone be enough to cause a serious deflationary scenario? And what are the economic implications?
Doug: Yes, and I would look at it somewhat differently. We have been told for decades that deflation is this huge, huge, paramount risk. I have always thought the over-arching risk for bubbles would be inflated by loose monetary policy and speculation. So the risk today is that we have a bursting bubble episode that is outside the control of central bankers. I can see a scenario where if inflation starts to be more of an issue, and I’m not saying 6-7% inflation, I’m saying perhaps 3%, and to me, that is very reasonable. All of a sudden that changes the dynamics and central bankers will have to become more aggressive. And all of a sudden, again, like 1994, bond yields start to go up.
That may pressure central bankers to actually tighten monetary policy, and that will be a different game, because right now the markets perceive that central bankers will not allow a meaningful increase in yields, and of course, that is a type of market perception that ensures there is all the leverage, all the derivative speculation, that if that unravels – and again, I can mention 1994, I can mention 1998, we have seen episodes like this – that can be very problematic for market liquidity.
David: Another question is:
Why not sell out of the money calls, short-dated, to purchase out of the money puts, in lieu of just being short?
Doug: Yes, that is an interesting question, and for some, that strategy would work for them for a while. For the Tactical Short we’re not going to be writing options. I manages those carefully, I can accept the risk of managing short exposure. I do not want to compound that risk by adding short option strategies, especially in this unsettled environment. I would see that as taking a lot of risk, to perhaps make a little bit of money. I will also add, I believe there is a proliferation of such call strategies, writing these calls strategies, and I think that might be playing a significant role in the current market melt-up. I know there have been a lot of calls written, different variations of call options on the market, out of the money. And a lot of those calls now are quickly in the money.
And to mitigate that risk, those that wrote those calls are in the marketplace right now aggressively buying the market indexes, which leads to a self-reinforcing melt-up and panic buying in the derivative marketplace. I have seen that in different markets throughout my career. I saw that in 1993, and definitively we saw the writing calls and the melt-up because of outstanding calls in the NASDAQ stocks in the 1st quarter of 2000. So I’m not going to do it – I know a lot of other people are doing it.
David: This question gets to – when do you get started? What was the timing of instituting the sort of strategy which Tactical Short represents? It reads:
We’re experiencing higher market tops continually. Is it safe to buy options or stocks, or wait out the markets until the crash, and things come down to an under-valued level? Or can we still invest and make a profit in this over-extended bull market?
And then the followup question, of course, is:
Why not wait to short until we see both credit stress and a meaningful decline before getting short?
Doug: Yes, good questions. I am biased, of course. I see this as the greatest bubble in the history of mankind, so I would say, “Throw no new money at this market.” People that have been in the market and are playing with the house’s money, that’s a nice position to be in. If they want to ride the wave and try to get out in time, I guess that is a reasonable strategy. It usually backfires on the vast majority of people playing that strategy. So I think the time to really focus on risk is now. I wouldn’t commit any new money on the long side. If I have money in the market and I want to continue to play the wave, I would start thinking about hedging exposure. We have a product – there are other products – we think our product is better. We hope people will consider investing with us. The question – why don’t we wait to short? Yes, that’s a fair question. I wish I knew when the market was going to turn, and I wish I knew that I could get a hedge on for people. So instead, I keep some short exposure on. I am a hedge, I am ready to act, I am ready to increase short exposure on a daily basis. I am managing risk carefully. I just don’t feel confident that all of a sudden there is going to be a market signal that says, “Okay, Doug, now it’s time to do it. You waited patiently and the market is saying go do it now, and everything will be fine.” It’s not that easy. Market tops are tough, and we do the best we can.
David: Next question:
Is this structured as an ETF fund or individual account, and if you’re managing individual accounts, do you keep all the accounts in the same percentages of the trades with the same durations? Basically, are all the trades equal, with the same overall performances?
Doug: Tactical Short strategy – it’s for individually separate managed accounts. Today all the accounts, and that is except for the newest accounts where short exposures have not yet been taken up to target. I’ve taken my time getting them to target. They have the same positions. We have a model portfolio and set specific position sized targets for all our accounts. But an important advantage with separately managed accounts is, with this format it allows us great flexibility. We can individualize exposures for specific needs or desires of account holders. That is one of the reasons we chose an SMA format, so they don’t all have to be the same.
David: IRA accounts are a little bit different and that gets to this next question:
Can we use IRA or retirement account dollars? If so, is the trading strategy for this option any different than a non-IRA account? Is there any impact to the performance between IRA and non-IRA account?
Doug: We do have strategy for IRA accounts. These accounts don’t have a margin account so these accounts cannot short stocks, but in this financial landscape that we operate in there are ample ETFs that give us the ability to have a negative correlation to be able to hedge without shorting, so we have that capability. Right now the performance of the separate strategies are very similar. There could be environments where there is dispersion between the two strategies in that we would not be shorting stocks in IRA accounts where we have a negatively correlated strategy. So there could be some divergence, but we can get negative market correlations, we can buy put options, we can implement a sound hedging strategy for IRA accounts.
David: The next question is kind of the skeptic’s question:
How useful are these theses when timing is so uncertain? Sure, market excess is historically over-valued and asset-wise, obviously, under-valued, or Z is clearly in a bubble, but here we are ten years after the global financial crisis with all the supposed corruption, debt, complacency, moral hazard, and basically, nothing has materialized that the “doomers” have predicted. I’m not sure I can actually use any of these ideas, and instead should just park my money in some sort of classical asset allocation and leave it.”
How would you respond to the skeptics?
Doug: Yes, the skeptics. And sure, the bearish perspective has been discredited. I’ve lived through this before. I would be chronically in this bubble for a number of years. I remember back in 2011 when the Fed came out with their exit strategy. I wrote one of my credit bubble bulletins, “No Exit.” The Fed’s balance sheet was 2.1 billion and they said they were going to reduce it back to pre-crisis levels, and I was confident they would not. I didn’t know at the time that they would again double their balance sheet to 4½ trillion over the next few years. Then 2012 came and we had whatever it takes in QE – that’s 14 trillion and counting. So I’ve seen a lot of confirmation along the way that the bearish thesis – let me just say, the bubble thesis – has been correct, as far as the unending financial fragility and the ongoing policy responses.
So I’m very confident in the bubble analysis. The timing of this – I always say, predict the timing of the collapse of a bubble at your own peril. That is not what I do. If someone wants to park their money in cash right now, I have no issue with that. Many people, though, have a diversified portfolio, and what we are trying to do is say, “Hey, there is a place for an allocation to a hedging vehicle to try to dampen volatility, to provide downside protection.” But if someone wants to sit this out, I will give them nothing but support.
David: On many of the things that we have put together, Doug, you and I, we talk about capturing the other 40%, which statistically, if you go back through 120+ years of stock market history, stocks are moving up 60% of the time and down 40% of the time. So smoothing out returns and not having major catastrophes along the way, for a long-term investor, is where Tactical Short is a complement to a long portfolio. So yes, we can provide a directional opportunity to be short and profit from that, but the majority of our clients have engaged us to be a volatility dampener, if you will, and provide positive returns when other parts of their portfolio are suffering. Again, looking at that 60/40 split, if the stock market is going up 60% of the time, 40% of the time it is pretty reasonable to have something that still represents horsepower, either growth or an offset to losses that you may have elsewhere. And that really is the structure of it.
Another question for you dealing with percentage allocations is from Daniel:
What percentage of your total portfolio would you put in something like this?
Doug: A lot of it depends on the structure of the entire investment portfolio. If it is a high-risk portfolio I would make a higher allocation as a hedge. If it is a low-risk portfolio, a lower allocation. We generally will say a 5-20% allocation. We think, for the vast majority of people that makes sense – 5-20%. For some, a large allocation might make more sense. For others, no allocation might make more sense.
David: This is a question about rotation:
If the stock markets collapses, wouldn’t it make investors run to the bond market for safety, driving interest rates back down, at least in the short run, as the dollar becomes stronger in value?
Doug: Yes, I would expect a rotation into treasuries. The market is trained for that rotation into safe haven treasuries. I can see and environment, though, where you get a significant de-leveraging in the sovereign debt markets and the markets become surprised, perhaps shocked, by rising yields in a de-risking environment . What is probably more important to me, as far as the market response, is not sovereign yields, not treasury yields, not boon yields. I will be focused mainly on corporate yields – corporate credit. Corporate credit has the closest correlation with equity returns, and if we get into a significant de-risking, de-leveraging, outflows, hedging, derivative issues in corporate credit, that is a major signal for a risk-off environment.
So that is what I will be keenly focused on. And a lot of times, if you see a flight into sovereign debt, let’s say treasuries and boons in particular, that can lead to a widening of spreads, and that can be very problematic for leveraged strategies, because there are a lot of strategies that are short treasuries to get enough finance to hold higher yield in corporate debt, or corporate structured finance.
David: While we’re on the topic of debt, I’m going to consolidate three of (sp? s/l John Allen’s) questions into one, and if we could, talk about the opinions that are swirling out there from the bond “gurus.” Being at the end of a bond bull market, for perspective, 200+ years of interest rates, and we have had cycles that have, at a minimum, run 22 years, and at a maximum run about 37 years. And we are at about 37 years now. So being long in the tooth, it doesn’t actually take a rocket scientist to say, “Rates could go up.” And by the way, we are at virtually zero, so odds are, at some point, rates go up from here. The ten-year treasury, you mentioned earlier on the call, 2.62. At what point on the 10, or on the 30, do you say, “We are beginning to see that big bond ship turn, and head a different direction, for the next generation?”
Doug: We might be getting close. I know before, Bill Gross always pinpointed that 2.5% yield, and we’re through it today. I keep an open mind. A lot depends on central bank policy. You don’t hear any of the so-called bond bears talk about a secular bond bear market. None of them have any dire prognosis. None of them reminisce about 1994. But also, I don’t think that’s where we go for our analysis of potential bond bear markets. It’s not like we’re going to go to Vanguard and ask them about the potential for a devastating equity bear market.
But I know the excesses over the past nine years dwarf anything we’ve seen in the past. It makes 1992 and 1993 look like child’s play. I do also know it’s global. I know it’s the perception that central bankers won’t allow yields to rise, and if that perception starts to falter, the surprise this year could be a significant rise in market yields. And again, where it gets interesting is, if we do have that surprise in yields, how to central bankers respond? Do they think that they need to catch up to the bond market, or do they think they are raising too rapidly, and will, at that point, have a lot more uncertainty as far as future policy-making?
David: It is interesting, Doug, some people do still hold to this idea that the Fed and the central bank community control the bond market. And really, by the same tools and techniques that a magician uses, they control perceptions, and they manage a mindset. And this is one of the reasons why, periodically, they completely lose control. Because it is not that they actually were ever in control of the numbers, themselves. It is that they can convince, in an amazing way, that they are capable of feats that no one has ever imagined.
And as long as they maintain that level of confidence, what they are managing is a mindset. That is what they lose at a certain point. The confidence game goes so far, and then it fails, and it is not surprising, the history of the markets for you or me, to see that people have forgotten how often they have lost control, and how just prior to losing control, everyone did assume that they were the masters of the universe. So price dynamics in the fixed income market will be interesting to watch in coming years.
We have some other questions that relate to a variety of other asset classes. Most of the questions relating to Tactical Short, we have gone through. This will be sort of a cornucopia of different things. So for those of you who are only interested in the Tactical Short, thank you very much for spending time with us on the conference call. We look forward to being in touch with you and answering any more specific questions you may have, or figuring out what the best way of moving forward would be – how we can complement your financial outlook and approach to the markets. And if you are interested in what we think about other topics, feel free to stay on the line.
There is a question there about China de-valuing, and this dealing with their re-balancing:
Do you anticipate China de-valuing their currency, the yuan, to spur exports?
Doug: That depends on the dollar. The dollar has weakened over the past year, so that has helped to de-value the Chinese currency. So that gives them some leeway. All of a sudden if we had dollar strengthening, then I think there would be more pressure on them to de-value. And I think they will always use de-valuation as a potential stick to use against the Trump administration if they want to play trade hardball, so it’s a potential.
David: I’m just reading kind of rapid-fire some of these:
What is your opinion regarding crypto-currencies as an inflation hedge, or as an alternative to gold?
Doug: A poor hedge for inflation, and a terrible hedge for gold. I am no fan of crypto-currencies. I’m sure, David, you have some thoughts on that.
David: I would just say that the crypto-currencies are not an alternative to gold. There is no alternative to gold, and it has been explored for 5000 years. Something might have changed in the last 18 months that is unprecedented in 5000 years, but I doubt it, as an alternative to gold. As an inflation hedge, I don’t think there is enough time and enough cycles to have anything really to say if crypto-currencies will in the future play that role. In the past we know that they haven’t, but they haven’t been through any real inflation/deflation cycles yet. So, the jury would clearly be out on that.
Another question from the same person:
Do you anticipate the break-up of the European Union?
Doug: I do, and that is one of the risks when the global bubble bursts. Italy is a problem child, and I think the euro currency will be a problem whenever the next crisis unfolds.
David: The next question is:
Gold, silver – how do they react in the context of a market slide sideways or downward? What are your thoughts from here?
I can answer that one if you want.
David: We’ve had an interest in the precious metals for almost five decades – 45 years – and what we see here in the last two years is an impressive uptrend. There are number of things that I think are worth looking at. One is that the price of gold is up in almost every currency globally over the last couple of years. And what that suggest is that you have a broad base of buying in the physical metals. On top of that, you have ETF purchases which were very strong last year, and also very strong in 2016. So looking back at what drives the price of the metals, it is made at the margin. So when investors start to get interested, even if it a little bit more than usual, it’s enough to start driving the price up. So for instance, 2016, if you’re looking at global ETF purchases, that was up 11.7 million ounces, and for 2017, a year later, it was up 14.3. There is only one year that was better on the ETF purchase side and that was back in 2009. So I would say very strong interest globally. Ironically, in the U.S., if you are looking at a year over year comparison between 2016 and 2017, U.S. ETF purchases, that is, U.S. investors interested in the metal, those purchases were down 92%. So, you are dealing with a global audience that says, “We’re not really as certain that tomorrow is going to be coming up roses for us, and we’re comfortable owning some physical gold.” In the U.S. there is zero lack of concern, zero interest in buying. So we’re the odd man out on the global picture – very robust buying globally, very anemic here. I would suggest that we, in the context of a market sell-off, would see a considerable increase in gold buying, just as we did circa 2008 and 2009.
You could argue, “Yes, but gold went down in the fall of 2008.” Surely, it did. As smart money began to realize that we were talking about a potential unwind of the financial system as we knew it, and all of a sudden counter-party risk was at the front of their mind, whereas I’m not sure that it had been even in the back of most people’s mind, as it became front and center people wanted a physical asset, a financial asset that was outside of the financial system. I think that is the reality, in the next go-round in terms of, let’s say, part two of the global financial crisis, I think you do have the investor demand for the metals pick up considerably.
So I don’t think it would move sideways, I don’t think it would move down. If it did, it would be very short term in nature on that downstroke. Because again, what you are dealing with now is the final straw of confidence relating to what we talked about in one of the previous questions – the masters of the universe. We are talking about the central bank crowd which has held things together, and confidence in the people who are supposed to know more than anyone else when that fails, I think you see more than a trickle into the metals.
So the next question:
I am helping manage a family trust, and am learning what I can do to do a better job with what I have worked with.
This is why Glenn is on the call today. Doug, do you have any thoughts in terms of, again, what we do on the Tactical Short that is a complement to someone who is trying to be that fiduciary for other people in a family, and manage across assets? Where do we fit in into a broad picture?
Doug: Excellent question. We want our account holders to have well diversified holdings across asset classes. We hope that they find the best managers that they can for whatever asset class that they are investing in. We want to help the process by providing a sleeve that helps provide downside protection, reduce the overall volatility of that portfolio, but also, we are hoping to build relationships. We are hoping, as this unfolds, that we are not only able to successfully manage part of their investment portfolio, but also provide insight that can help them manage through a potentially very difficult environment. We are hoping to develop relationships, manage the hedge well, and provide insightful analysis along the way.
David: There are a number of other questions here, Doug. Some of them are specific, even more specific to product offerings that we have in our MAPS portfolio strategy, allocation questions relating to that, through Dave Burgess and the rest of the team on the McAlvany Wealth Management team. There are also some questions dealing with storage of precious metals and what not. I’m just going to ask the audience, if those were your questions, please allow me to email you directly with a response so that you do have that answered, but I want to be respectful of everyone’s time who joined us for the Tactical Short today.
We’re looking at 2018 as a remarkable opportunity, and the idea of partnering with you – we put this in motion as an offering that we considered unique in the marketplace, with the best talent, in my view. Doug is not dislocating his shoulder patting himself on the back, but I might pat him on the back. We have the best talent, if you want someone to be hedging actively, managing the risk in a portfolio like this to complement the rest of your financial picture. As a family-owned business, as a second-generation wealth manager, we’re interested in the long-term relationship, and for you to engage with us. Just understand that everything is high-touch, very professional, and we want to cater to the individual needs of a client, which is why in the coming weeks if you would like to have a one-on-one consultation, either with me or with Doug Noland, to see how this is a fit for you, we can schedule that, and we look forward to spending that one-on-one time with you. Obviously, this is something that would be preferable around market hours, after market hours, and we look forward to accommodating as our schedule and yours permits.
Again, thank you for joining us tonight. We have folks that have joined us from all over the United States, but also, in addition to the United States, Spain, France, and Uruguay. Thank you for joining us from overseas, thank for joining us East Coast, West Coast, and throughout the Midwest. It is our privilege to partner with you and to work as hard as we can for you with the skill set that we have been given and honed through the years.
That will wrap our quarterly conference call. We look forward to next quarter, and any of the questions that may arise between now and then. Feel free to reach out to us, and we look forward to entertaining those conversations. Thanks so much.
Doug: Thanks, everyone. Sure appreciate it, and good luck out there. Bye-bye.