Through the Eyes of a Hedge Fund Manager
Anytime I have an opportunity to hear a hedge fund manager speak, I always make time to listen. While they aren’t always right, what they do have is an access to volumes of information and people to help them interpret that data. What I take from these conversations is a much larger picture of the economy and the markets than I can see from my vantage point alone.
Last week, hedge fund manager Mark Yusko, the CEO of Morgan Creek Capital, was interviewed on Macro Voices, a podcast put on by hedge fund manager Erik Townsend. Macro Voices is a high-level podcast and fortunately, I am a registered user so I had access to the entire podcast and the 150-page PDF chart pack that Mark put together for it. Even though I had planned to write about how the United States may try to get itself out of the next financial mess, I thought it would be interesting to share with you Mark’s views and my thoughts on them.
Before I get started, it’s also worth mentioning that Mark has recently taken on a second challenge set forth by Warren Buffet. Warren doesn’t believe that hedge fund managers offer much value and to prove that, ten years ago he bet a hedge fund manager that the S&P 500 would beat him. It did. Warren is looking to make this bet again for the next ten years and Mark jumped at the opportunity. Based on market cycles alone, Mark should be able to beat the S&P 500. If I had a spare million laying around I would pit Portfolio Shield™ against the S&P 500 because I know it can beat the S&P 500 over a ten-year period. But I don’t.
Mark is bearish on the US dollar for several reasons: an aging population, too much debt and persistent deflation from continued technological advances. He cites the upward move in the dollar two years ago was because the dollar tends to anticipate the moves of the Fed by rallying in advance of a tightening cycle. The dollar then tends to start falling after the second rate hike which it has done. He also believes we are entering a world where fewer dollars are needed, thanks to the petrodollar system. Simply, when oil is selling for $150 per barrel there is a greater demand for dollars than when it’s selling for $50 per barrel. Lower oil prices lead to lower dollar demand.
He also sees the eventual end of the US dollar as the world’s reserve currency. Reserve currencies last somewhere between 90 to 100 years and we are coming up on our 100-year mark. If the dollar loses its reserve status it won’t be overnight, because other countries still need US dollars to facilitate trade. While transitions can take a decade or longer, the impact of such a change will mean the United States will no longer be able to print money at will. This will be a problem given how much we deficit spend.
I agree with Mark’s view on the dollar. The reason there is a demand for dollars is due to the petrodollar system, which converts oil to dollars, and the need to trade with the United States. As China rolls out their petroyuan system and the Boomers move into retirement, there’s a strong argument against the dollar. Oil producers will likely choose gold over dollars since gold can’t be debased or devalued, which the United States will likely be forced into doing. As far as trade goes, consumption should fall as the Boomers age, because people buy fewer things as they age. And since the United States doesn’t produce many goods, our foreign trading partners don’t need to hold as many dollars. There will be demand for dollars in the early stages of the next recession as investors buy dollars as a safe haven, but after that, there is a strong case for the secular decline in the dollar.
Mark doesn’t see an end to the central bank’s money printing schemes. He believes that the Fed will be forced into another round of Quantitative Easing where he thinks they will buy bonds and stocks.
I’ve been outspoken that there will be a Quantitative Easing 4 or some variant of that for a while now. One thing to understand, which goes back for the demand for dollars, is that because the United States produces so little, our foreign trading partners are increasing their trade amongst each other. Right now, due to the petrodollar system, dollars must come back to the United States to facilitate trade. Most commonly the dollar comes back in the form of a US Treasury bond, but foreigners also buy dollar-based assets such as stocks and real estate. As those buyers of assets fade due to fewer dollars, the Fed will be forced to pick up the slack in an attempt to prop up equity prices.
Speaking of equity prices, Mark thinks the stock market is overvalued, but that doesn’t mean it won’t go higher. He says that most bubbles are the same and that those bubbles have a two-year mania phase that ends with a “blow off” top. A blow-off top is best described as a short period where prices quickly go vertical. This market hasn’t seen a blow-off top yet, and it’s hard to know if we will have one. According to Mark’s research, to match the extreme overvaluations of the 1929 market, the DJIA would need to reach 24,000 and the S&P 500 2,800, which is about 10-12% higher than where the market is today. The “central bank put,” which is associated with the willingness of central bankers to implement policy tools to prevent the stock market from falling, is the reason many cite as why it is safe to buy stocks without worry. Mark is quick to mention that under Greenspan and Bernanke stocks fell 50%. There’s little doubt in Mark’s mind that there won’t be a blow-off top followed by a massive drop in stocks.
I don’t agree with Mark’s view that every bull market ends with a blow-off top. In October of 2007, the S&P 500 didn’t have a blow-off top – it had a double top and then Lehman Brothers imploded. From there the S&P 500 dropped nearly 60% in a fifteen-month period. The reason I don’t think there will be a blow off top is that trading volumes are low, sentiment is high and equity ownership is extremely high. What that tells me is that the public has already bought, but the “smart” money still thinks there is cash on the sidelines, which is why the market gets driven slightly higher each day.
Upon examination of prior bubbles, trading volumes rise as markets peak. This is because more and more people are buying which increases volumes until the peak is reached. Currently, trading volumes are back where they were in 2004-05, which isn’t a sign of stock mania. Public aside, blow off tops happen when short sellers close out their short positions to buy stocks. Given that short interest is already low, I’m not convinced there will be a final surge in stock prices. But I will probably be wrong.
Mark believes that equity markets will crash, but not until early 2018; at least not until the blow-off top occurs. He thinks we had a very mild recession in 2015-16 that affected a small number of sectors. But had it not been for China and their $4 trillion of stimulus that things would have been much worse.
Based on valuations, Mark cites the median price-to-sales ratio, which is at an all-time high, as for why this is the most expensive stock market in history. He thinks the DJIA will likely drop 19,000 points, but not before it makes its final upward 2,000 point thrust to 24,000. Yes, he thinks the Dow will bottom at 5,000 points.
While I have no opinion on how far this market will fall, a drop from 24,000 to 5,000 points on the Dow, if Mark is right, would represent an 80% drop. Is an 80% drop unrealistic? No. The Nasdaq dropped 82% after the dot-com bust and this is a much larger bubble than we saw at the peak of that bubble.
When asked about the popular short volatility trade, Mark quickly points out that equity volatility is lower than bond volatility, which makes absolutely no sense. He said the last time equity volatility was lower than bond volatility we had the Great Financial Crisis.
Over the past year, I have written and talked about the risks in the short volatility trade which will eventually unwind in a spectacular way. Traders can continue to suppress volatility, but as times passes, it takes more money and lower volatility to keep markets up. I don’t know what will trigger a spike in volatility because so far nothing has, but whatever does, will likely cause a massive unwinding in stock prices.
When asked about the effectiveness of central bank’s money printing scheme, Mark doesn’t think it was effective at all. He doesn’t see any way out of our current situation and doesn’t think central banks will ever be able to shrink or unwind their balance sheets, short of buying all the debt and having a debt jubilee. Mark points to the Labor Force Participation Rate which has been falling, along with consumption, as a reason central banks will continue to print money to buy assets in hopes to prop up the economy.
In a sense, the Fed (and other central banks) is printing money to take over where the Boomers left off. Consumption falls as people age and with the largest demographic cohort in our country retiring, their consumption will continue to fall. If the Fed follows through with their plan to reduce their balance sheet they will likely crash our economy and the global economy.
On fixed income or bond yields, Mark believes lower yields are ahead of us. Bond yields tend to follow working-age population growth, which is declining and expected to continue declining as Boomers retire.
I agree with Mark’s view. Bond ownership is also at multi-decade low levels due to Fed intervention and when the next recession occurs, money will flow into bonds which will likely drive yields to new historic lows.
Mark believes that Quantitative Tightening will lead to deflation as consumers, businesses and municipalities come to grip with all the debt they hold. When asked what he likes as investments, he feels that commodities, such as gold and oil, are about to enter a new super cycle.
The last time there was a commodity super cycle, gold rallied 300-400%. When you factor that mining stocks tend to double the performance of the metal, then you can understand why I’m so interested in gold and silver miners. But more on that in the weeks to come.
Video Topic of the Week – Is the Market Broken?
The stock market continues to shake off all bad news and respond to good news. Something is odd when the markets have a greater response to wage growth than it does another potential missile launch.
Chart of the Week – Service-Producing Less Goods-Producing Payroll Growth
All the news surrounding the payrolls report today is how bullish it is for the US economy. When you look at the trend in service-producing job growth compared to goods-producing job growth, it doesn’t seems quite that bullish.
Portfolio Shield™ Update
The allocation went back to a full equity spread for the month of October, which was expected based on the recent move in bond yields. There is a glitch in the Morningstar® software which is preventing me from sharing the latest report, but as soon as that is worked out I will include it in a future update.
I am working on expanding the Portfolio Shield™ lineup and I will be announcing some new strategies in the weeks to come.
Weekly Sector Commentary
Broad Market / Economy
The ISM manufacturing and survey data came out this week showing near record high levels from the manufacturing and services sector. At face value, one would interpret the headlines to mean we are experiencing a booming economy. Until you look at the fine print where you see the survey data is higher because input prices are up and supply times are up – both of which are likely transitory effects from the two hurricanes.
Stocks continue to grind higher regardless of what is printed in the news, with a bias towards higher performance on days with bad news. Sentiment levels are very high and in some cases divergent from where the indices are trading. Even though the news suggests this is one of the most underloved markets in history, based on sentiment and the amount of household wealth tied up in stocks right now, this is the most loved market in history.
I find myself impressed that the market is going higher even though the Fed is starting to unwind their balance sheet this month and is likely to hike interest rates one more time this year. History has repeatedly shown that buying stocks at current valuations ends poorly, yet it hasn’t stopped everyone from going “all in.”
The biggest push this week is likely stemming from the largest amount of short volatility positions in history, meaning hedge funds and other investors are continuing to suppress market volatility which forces prices higher. I have no explanation for why investors are doing this because it is a very dangerous investment that could potentially go to zero overnight, but because short volatility is going up, people are throwing money at it.
What will someday be known as a volatility bubble, by supporting asset price inflation, the Fed has coerced investors out of defensive assets and into risk assets. Investors have willingly made this exchange due to the Fed’s low-interest-rate policy. As the economy continues to weaken, the Fed has started to change their tune about the effectiveness of monetary policy. But at the same point, they have herded investors into risk assets and given them no way out, which is why there will be a substantial amount of dead air under this stock market once it finally turns down.
The most interesting place in the market is U.S. Treasuries, which despite a very high level of short interest, has not sold off. Under the belief that unwinding the Fed’s balance sheet will spur inflation and higher yields, traders have entered very large speculative short positions on Treasuries. The markets haven’t seen short Treasury positions this large since 2005!
Why I find this interesting is while yields have risen, they haven’t risen back to their recent highs. This short move should flush bond investors out and into stocks, but what I find interesting is that there isn’t much selling of Treasuries going on. Meaning Treasury investors have the conviction that the economy is headed into a recession. If there isn’t a bigger sell-off in Treasuries, which I’m not expecting, there will likely be a short squeeze on these traders which will cause yields to fall.
This short position doesn’t make much sense to me since credit bubbles are inherently deflationary. As more consumers, businesses, and municipalities stack on higher amounts of debt, that debt takes up more of their discretionary spending. When this bubble pops, the debts will still have to be paid, meaning asset prices will fall. Hence my deflationary view.
On a side note, for those who think interest rates are headed higher, including US Treasury yields, German high yields bonds (or junk bonds), now have a lower yield than US Treasuries.
Add that to the list of reasons I believe that Treasuries are going to rally during the next recession.
International / Emerging Markets
UK and Emerging Markets, the two I’m most interested in, haven’t been able to confirm a resumption of their uptrend.
I had the opportunity to get classical chartist Peter Brandt’s view on both oil and the dollar. Based on the charts and open interest, his view is that WTI is more likely to head to $30 or even lower.
Looking at the oil explorers and producers, it’s clear that stock prices tend to follow the 100-week moving average, which has been in a downward trend for quite some time. What that means is there will likely to be a tremendous opportunity in the oil sector, but that’s not today. Much of this depends on how successful OPEC can be to contain production.
Peter had a very interesting view on the dollar. He said based on the charts and open interest that the dollar is poised for a strong rally, which at last in terms of oil, would support his view that oil is likely to head lower. Over the long-term he didn’t indicate what his view was, but in the shorter term he thinks it’s due for a rally. This would make sense if there is a global recession since the dollar is usually seen as a safe haven. Sentiment is rising, even as the trade weighted dollar is relatively flat.
Gold futures remain stuck under their 50 and 100-day moving averages, which would indicate a retest of its 200-day moving average at approximately $1,250/oz. Meanwhile the gold and silver miners are trying to stage a rally. The gold miners closed above their 50-day moving average after being stuck between their 50 and 100-day moving averages.
With Golden Week ending this could trigger the beginning of our move in.
After a few weeks of strong volume without any significant price moves, agricultural commodities have closed above their 50-day moving average, which is generally a bullish indicator. My opinion on selling the next rally hasn’t changed.