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About this week’s show:
- What is a credit bubble?
- How misallocation of capital distorts market pricing
- What you can do about it
About the guest: Doug Noland served as senior portfolio manager of Federated Prudent Bear Fund, Federated Prudent DollarBear Fund and Federated Market Opportunity Fund. With more than 20 years of investment experience, he leads the nine investment professionals who comprise Federated’s Alternative Equity Management Team. Before joining Federated, Doug was employed with David Tice & Associates, Inc. where he served as an assistant portfolio manager and strategist. http://creditbubblebulletin.blogspot.com
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“My job is not to predict, it is to have a sound analytical framework, to work very hard to be on top of developments, to be able to react. And we’re going to have to react. There are going to be some major decisions that we’re going to have to make to protect ourselves, and it’s going to take a lot of focus, a lot of determination and hard work to play this well going forward – a real challenge, but an exciting challenge.”
– Doug Noland
Kevin: Part Two of the Doug Noland interview is today, Dave, and I’m looking forward to it, because there are particular things that a person can do if they can analyze a situation correctly. Without going into great detail, Doug brings up some great birds-eye view things to do with a portfolio to guard against what’s coming.
David: As you know, in musical theater there is such a thing as a triple threat, and that is someone who can dance and sing and act, and sometimes there is a gifting in one area only, and maybe you just don’t go as far if you only have that one particular gift.
Kevin: Are you saying Doug is a double threat at this point?
David: He is a double threat – CPA, MBA – you have to know where to look for the details and then you have to know how to put them in context to know what they mean. One is data accumulation, the other is data analysis and I think what makes him a triple threat is then taking it to, “and here’s what you do about it.”
Kevin: And it is many years of experience. I can remember back in the 1990s reading Richebacher’s letter and thinking, this is one of the best letters about central banking that I’ve ever read.
David: Little did you know you were getting some help – he was getting some help from Doug. Without further ado, a continuation of our conversation with Doug Noland.
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Doug: I want to go back a little bit, too, in that for a while I’ve argued that we’re in a unique period in financial history. Throughout history there have always been constraints on money and credit. I’m seeing for the first time ever, there are no constraints, globally, on the quantity or the quality of credit, unlike anything in history. Because if you think historically, you had a gold standard, you had Bretton Woods with the dollar standard. Probably, more importantly, traditionally, credit was expanded through bank lending, and bank lending was constrained by capital reserve requirements. The old fractional reserve banking restrained credit growth somewhat.
In the 1990s we went to securitized finance, specifically, financing rise in asset prices. So all of a sudden there is no constraint at all on credit – unlimited supply of credit. And I’ve argued that capitalism can’t function with an unlimited supply of credit because on the financial side, as we saw during the mortgage finance bubble, you have a huge demand for mortgage credit and the cost of that credit went down. It wasn’t self-regulating. On the one hand it has been a very, very powerful credit system to expand credit like this, to focus on the asset markets, to focus on financial wealth. Central bankers figured out how to intervene in the markets and back-stop this system, to use this system as the most powerful monetary mechanism for stimulus ever.
But now they’re stuck because they want to inject money into the real economy. They argue there is insufficient aggregate demand, so they want to inject liquidity into the economy, but they’ve created this massive financial sphere. I break them down into the economic sphere and the financial sphere. You have this massive financial sphere that just gets inflated larger and larger every year because of all this large credit creation every year. It has turned wildly speculative, and the only way they can control this financial sphere and this massive pool of global speculative finance is to continue to force security prices higher.
Today, with security prices at a record – that’s bond prices and stock prices – it looks sustainable, but I don’t think that they can control this global pool of speculative finance much longer. So they’re really struggling because their framework, they don’t look at this pool of speculative finance that they’ve created, they look at money and credit as this mechanism to drive commerce, this medium of exchange when the key role of money today, as it has been historically, is as a store of value. It’s that store of value that is coming back to keep them, I think, awake at night, because they know if there is any waning confidence in money and credit, they’re out of solutions. They’ve thrown the kitchen sink at this. They’ve already done more than whatever they thought it would take in 2012.
David: This is really critical because we’re talking about a slight variation on the definition of money. I would say that money is a store of value and a medium of exchange, where both of them are important. You’re saying that the new definition of money – the change in the nature of money has changed the nature of credit, and the change in the definition of money was to drop the store of value and just leave it as a medium of exchange. That may seem small, but that’s a game-changer.
Doug: Well, it’s huge, and it gets back to John Law and his failed experiment. John Law, for those who are unfamiliar, it’s just a fascinating part of history. Back in 1717-1720 in France, John Law introduced paper money to France, and he was a hero. They used to set up and have a carnival outside his residence because he brought this prosperity to France until the Mississippi bubble collapsed, his whole money and credit system collapsed, and they ran him out of town. I’ve read where in France they didn’t trust banking for 100 years after John Law, and it led to a lot of mayhem. To me, I have a definition of contemporary money. It’s a store of nominal value that is highly liquid. People trust it.
The reason money is so important is that people trust it. They basically have insatiable demand for it. It gets back again to the comment I made about junk bonds. You can only create so many junk bonds, so much junk credit, because people know it’s risky and they have a limited appetite for it. This money, today, if people trust it, it can be issued as governments have done throughout history, in gross excess to the point of a crisis of confidence and a collapse in value. That is where we are today, and that is where contemporary economics is very weak on money and credit, and dismissive of the vital importance of money as a store of value.
David: What is interesting, and this is also in contrast to the view that Richard Duncan has, that capitalism is dead and creditism has taken its place. You would say, no, quite the opposite, there is an alive and vibrant capitalism in the real world economy, but there is another corrupted form of capitalism which is in the finance sector, and it exists today at excessive levels because of the change in the definition and use of money, and therefore the expansion of credit. So if you’re looking for a place to refine, regulate, control, re-work, it is in the finance sector, but actually, there is a vibrant capitalism in the real world economy that is a separate and distinct kind of capitalism from what you have in the halls of finance.
Doug: Right. This is a very distorted, unhealthy capitalism, but I just continue to call it capitalism, and I expect for the rest of my life I’m going to be defending capitalism. Capitalism has not failed us. Finance has failed us. As I have argued, I don’t think capitalism can function very well in the real economy if on the financial end you have unlimited amounts of cheap finance, because that distorts the allocation of financial resources, that distorts the allocation of real resources, it leads to huge excesses in speculation, huge distortions in the nature of savings and investment. As we have seen, that type of a backdrop leads to an economy that loses its vibrancy, has huge inequality, social tension, a lack of productivity.
So that is why, if we want to get to the root of the problem we have to direct our attention to finance, and on the finance side, get, again, to the heart of money and credit, get the government out of this, so we can start to have financial markets that function more normally, that are self-adjusting, self-correcting. I would love it if we had a gold standard. Unfortunately, I don’t see that as feasible. So what we have to do is do the best we can to structure our financial sphere that is self-regulating, that has a limited supply of finance so when you have a demand for that finance, that price is determined by the interaction of supply and demand. And if you have significant demand for finance the price goes up and it will regulate itself.
David: You are also arguing that under what Jim Grant would call the Ph.D. standard, self-regulation does not happen, and cannot happen, because that’s the nature of a discretionary monetary policy. The Ph.D. standard is where you have, today, at present, 700 Ph.D.s running our monetary policy and they do believe that their decisions are better than anything that would happen on a normal consequential basis in the marketplace, that they can, in fact, manage the whole process for a better outcome. But again, they are impossible to bring together, the Ph.D. standard and the market being self-regulating.
Doug: (laughs) Yes, the Ph.D. standard means that a small committee can manage the markets, and backstop the markets, and if a speculative market believes that they are going to do that, then they are going to speculate more and feed the bubble, and the larger the bubble the greater the government meddling, to the point where you have negative interest rates and QE. So, the Ph.D. model is an abject failure, except we haven’t paid the price in the markets yet. I just look at the real economy and I think, again, we need to reduce the addiction to credit, and we could do a couple of things that I think would profoundly change the backdrop and move us toward a more stable financial sector.
The U.S. has been running current account deficits for going on 25 years. That means every year we consume more than we produce, and we basically import goods and trade financial IOUs, and these IOUs go out into the world and feed excesses out in the world. So if we had a new type of focus where countries were going to balance their current accounts, and central banks had some clear rules – let’s say if credit goes above a certain amount, either nominally or percentage-wise, that rates would mechanically rise. Right there, if you did a few things, you would have a much more sustainable system. Instead, the government imposes its will on the marketplace to ensure you have significant credit growth inflating asset prices, large, ongoing current account deficits which just feed global financial and economic imbalances and lead to this unstable financial and economic backdrop.
David: In January of this year it appeared that the global markets were on the edge of dislocation. We then had various central banks come in with promises and props, and the tension seemed to clear. That has brought equity markets in the developed world back to higher levels, some stability in the emerging markets, selectively, and in the U.S. we’re now at record levels. We’ve done this over and over again. Again, the argument would be, “Well, gosh, it worked last time.” January we actually began to see a real correction on the edge of what could have been defined as a bear market, if you use the Wall Street bear market terminology or reference of down 20%.
And yet, here we are. We’ve forgotten that January even existed because we’re going to finish at record numbers for the year. Why not just continue on? Are central banks going to be unable to perform the same thing over and over again? Because, after all, we have monetary policy, which is what is still in play, and we haven’t even transitioned toward radical fiscal policies yet. We still all of the fiscal policy rabbits to pull out of the hat.
Doug: Right. Going back to January and February, very interesting dynamic in the marketplace. Rightfully so, market participants were worried that whatever it takes wasn’t enough. They were worried that interest rates really couldn’t go lower, that central banks had basically used all their ammunition. They were worried that the China credit system bubble had burst. But then you saw a dramatic policy response, where the Japanese said, “We can go as negative as necessary.” The ECB said, “We’ll increase. We can do QE as necessary. We’ll buy corporate bonds. The Fed, instead of starting to raise rates, it was one and done.
So that sent a very important message to the markets that it was concerted, whatever it takes, that there was no limit on how low interest rates could go, there was no limit on the size of QE, there was no limit on the type of assets that the central banks were willing to buy. So that was profound in the marketplace. They went from worrying that the game was almost over, to wait, this can go much longer, for these central bankers there are no limits. Also, I think since February we’ve had an enormous short squeeze in the markets. There were significant bearish positions put on for sound fundamental reasons. There was a lot of hedging in the derivatives markets, and we’ve seen a major unwind of those hedges and those short positions and that feeds on itself.
And then I mentioned the dislocation in the bond market that I believe has created enormous amounts of liquidity, that has added liquidity into the corporate debt market, the emerging markets. So you’ve really had a melt-up in the markets, in the face of deteriorating fundamentals, not unlike late 1999 when NASDAQ hit its high in the first quarter of 2000, when as analysts we were looking and saying, “Wow! Amazing short squeeze in the face of major deterioration in the fundamental backdrop.” And then even when subprime cracked in 2007 and it looked like the bubble had been burst, you had an enormous rally in the markets in the face of deteriorating fundamentals, and I often argue, bubbles can go to unimaginable extremes and then double, and also, things get crazy at the end. You get this dislocation in the market, you get these short squeeze dynamics, and that is what we have seen over recent months. I think it is really unhealthy.
But everyone got bullish again and the perception is that central bankers have it all under control. But at the same time, I always follow financial stocks closely. They are always a good indicator of the health of the system. I believe Italian bank stocks are down 50% so far this year, European banks stock, I believe it’s 30%, Japanese bank stocks, I believe, are down 40%. U.S. financial stocks are negative. They have lagged the market badly. So there are indications that all is not well and I think at the end of the day, central banks are putting the global banking system in a very perilous position, inflating these asset markets, distorting the economy, and these obligations end up on commercial bank balance sheets. They end up holding a lot of central bank credit and they end up extending a lot of loans into a bad part of the cycle. So this is very detrimental for the banks and I think people should focus on what is going on below the surface of record stock prices.
David: Is there a bit of irony in the 2007-2008 period, beginning a cycle of interventionism by the world central banks to save the too-big-to-fail institutions, and now the central bank policy which has continued on for the last seven or eight years may, in fact, be responsible for the death of some of these big entities?
Doug: Absolutely. I’ve argued a few things. We took too-big-to-fail for major financial institutions, we’ve taken too-big-to-fail for global financial markets and global asset markets, and I used to argue during the mortgage finance bubble, I talked about the moneyness of credit. Government intervention was able to transform very risky mortgage debt into triple-A rated liquid securitizations. We had made credit money this cycle, and I’ve argued this in recent years: this has been about the moneyness of risk assets. Central banks have tried to make risk assets money-like.
If the markets perceive something is liquid and safe, that’s often where the crisis will occur because a lot of money will flow into an area with that belief of liquidity and safety, and if all of a sudden the market sees that their perceptions were misguided, and they quickly want to get their money back, that’s when you have a crisis. That’s part of the dilemma right now, these central banks have so distorted the markets where you have literally had trillions of dollars flow into what is our perceived safe assets, and that is the perceived low-risk spectrum of equities, corporate credit, obviously sovereign debt, and that is where the biggest bubble is.
The central bankers have convinced the markets through their interventions and QE that these financial markets are liquid, that they will always be liquid, and that is very dangerous. Back in 1998 the perception in the markets was that the West will never allow a collapse in Russia. It was that faith, that confidence, that led to a lot of illiquidity in Russian instruments, a lot of derivative trading, and when the crisis came you had a big blow-up. There was a perception throughout the mortgage finance bubble that Washington will never allow a crisis in housing, will never allow a crisis in mortgage-backed securities. It’s that perception of safety that led to the excesses which ensured a crisis. So today, central bankers are trying to ensure there is never a crisis. Well, that creates the backdrop for, unfortunately, I fear, the biggest crisis ever.
David: So convinced of liquidity, people are treating Italian bonds almost the same as German bonds, with there being maybe a 20-25 basis point difference in the spread between them. What you are suggesting is that when people all of a sudden look at them with a more objective view, they will recognize the difference in credit quality between the Italian and German, and all of a sudden in that moment there is no one on the other side who is willing to, with open arms, take on and buy, provide a bid, for Italian debt as opposed to German debt. So today it trades at a very comparable price, very competitively, relatively speaking, and that can disappear, be unhinged, in a moment.
But you are also saying that you see the same kinds of strange pricing dynamics, with corporate bonds, with junk bonds, with emerging market debt, with dividend payers, with low-volatility stocks, the kinds of things that people have plowed into because they can’t get the magic 5% from their bank deposits to make ends meet as a retiree or as a pension fund or an insurance manager, portfolio manager. They are having to get more creative. And it is creating a crowding effect in an area where you wouldn’t normally expect to have liquidity, but today, you’re convinced that you’ll have all that you’ll ever need.
Doug: Yes, this is very complex material. Let’s take, for example, the hedge fund universe. The hedge funds have a lot of institutional clients – pension funds, endowments. They need 8% return. How do they get 8%? The leverage number is the plug. If the yields come down in corporate debt they are going to leverage to get that 8% yield. That is one distortion.
You also have this distortion in the markets where the government involvement is so egregious that it is very difficult to do fundamental analysis, to analyze risk, to analyze return. Active management is out of favor because a lot of active managers are trying to navigate around the risk, and if they see the risk start to come to a head they’re going to pull back exposure, and then if central banks intervene, then they miss a rally and their performance suffers, and they lose assets. So the assets, because of this backdrop, have gravitated into the indexes. Why not just, “Okay, I’ll just invest in corporate debt. I’ll just invest in this fund to get this yield.”
So that has moved completely away from fundamentals – completely away. Risk doesn’t even enter into the question. So you’ve had the ETF industry grow to three trillion. I couldn’t believe the hedge fund industry went to three trillion, I think it was at 35 billion when I started back in 1990. So we have all these dynamics that distort the market, but now, even when risk is so high and the central banks are in desperate measures, you have a wall of liquidity going in to play yields, not even concerned what the risk is, because they want to get the yield.
So the markets have been so distorted, I say, in this type of environment it’s not even investing, because to invest you look at fundamentals, you look at risk, potential reward, and you make a very careful calculation. There is no calculation going on here, it’s like, “I need a return.” Or, “This fund made this much last year.” And the money just flows in. And that’s part of what has turned this into just a huge speculative bubble. Again, it’s the moneyness of risk assets, where I don’t think investors have conviction in the asset, this is purely chasing returns, and when the returns turn negative, you will have outflows and the downside of a difficult market cycle.
David: As Kevin mentioned in the introduction, one of your specialties for the years has been shorting the markets and recognizing opportunities to do so, and as asset prices fall, actually benefitting on the downside. That brings to mind, what do you do when you get to a point of excess in the markets, you’ve had a market melt-up in the face of deteriorating fundamentals? But bubbles, as you said, can get to extreme levels and then double from there. So, shorting the market is not for the faint of heart. It’s also not for the person inclined to do this on their own. This is an expertise you have had for 25-30 years. What else would you do? If you want to protect on the downside, with having a short portfolio, what else makes the most sense if you’re managing intergenerational wealth?
Doug: In this environment it is very challenging to develop a sound investment strategy. From my perspective, the risk/reward in securities is very unattractive. That is corporate debt, sovereign debt, that is equities. I haven’t been managing money for the last 18 months, I’ve been watching on the sidelines, and as an analyst of bubbles, with a specialty on the short side, I’ve been happy to be watching from the sidelines, because as I said, things get crazy at the end.
My focus is, I’m getting geared up for a change in the environment, and I think a once-in-a lifetime opportunity on the short side. It will not be easy, these are going to be treacherous markets, but I think they are definitely the best opportunities of my career unfolding. I don’t know the timing of when this unfolds. I know that I’m picking up the pace of my analysis right now, getting my analysis together, getting ready for this opportunity, but the volatility right now is very, very difficult to play, to know what the best strategy is.
David: It is particularly challenging, as you say, when fundamental analysis, or a thoughtful process going in is discounted. You would expect to see a rise in risk premiums with greater stresses in the financial system, yet, central bankers so willing to use their balance sheets as a giant mop, cleaning up the mess, risk premiums have all but disappeared. We don’t have the signals. The things that would tell you that instability and fragility are all around us, interest rates being one of those key tools, have become an unreliable gauge.
And it seems that this environment is particularly dangerous because no one is looking at that and saying that, in itself, is a problem. When you can’t get a read on risk, or a benchmark for risk, when that has completely been distorted, and then you just throw caution to the wind, as you say, the response is not to hunker down to try to figure out how best to navigate these waters, it is just, “Look, I must have – must have – a return on investment, and I’ll go where I can to get it, or I’ll be out of a job.” That seems fairly reckless.
Doug: It is reckless. Unfortunately, it’s rational. In the environment that has been created by the central bankers people have to plan ahead to try to have savings to put their kids through college. Financial advisors are doing the best they can for their clients, but they also know that if they don’t participate in a strong rally they’re not going to have a job. It’s the same with fund managers. I wish the market signals were more helpful. I am trusting that they will be in the future.
Let me throw out – I probably should have thrown this out in my answer to your last question. What I do, personally, I don’t own stocks, I don’t own bonds. For myself, it’s a barbell approach. I want hard assets, and that is gold, silver, precious metals. I want real estate that I think is special. And I’m going to hold cash for future opportunities and for safety. As a professional with a focus on the downside of the market, I am going to be waiting for a tightening of financial conditions.
That is my analytical framework. If I see a tightening of financial conditions, if I see risk aversion, de-risking, de-leveraging in the marketplace, like we saw back in December, January, and February, that is when I turn more constructive on shorting – shorting select stocks, groups, the market. But then, if you get a policy response, and that policy response leads to a market loosening, leads to risk embracement, leads to short-covering, more speculative leveraging, then I have to back off again and wait for a better opportunity in the marketplace.
David: So a couple of things that you just said. One is that to play the short side of the market you don’t always have to be short, you just always have to be nimble. And that is, ready for when an opportunity emerges, willing to make a tough decision tactically, and then willing to reverse course in the case that there is a policy response to that financial deterioration. That’s wonderful. What I just heard you explain, in terms of a barbell approach, I’ve used those words, precisely, with a few friends, to say, “Look, this is so simple, you don’t even need a napkin to put it on.” Ordinarily, when you describe something that is very, very simple, cut and dry, you say, “Well, I’ll just write it down on the back of a napkin.”
You don’t even need the napkin. The barbell approach, having real assets on the one hand, cash on the other, is probably the best strategy in the environment we’re in. You can make it more complex than that, you can bring stocks and bonds into the mix. In some instances, you have to, if yield and income is a requirement, but again, your risk has to be carefully managed in that environment. But the ideal situation is to not take risk when the reward is lacking, and that is what you’re saying. We’re in an environment where risk and reward are not in balance. Reward is not on offer and you’re being asked to take far more risk than you can even fathom, given the amount of leverage in the system, given the fragility of the derivatives market, etc.
Doug: Yes, excellent, excellent. We have no idea, and I devote an enormous amount of time trying to get a gauge of this, I have no idea what the future risk profile looks like because I don’t know the policy response. I suspect the Fed’s balance sheet is on its way to 10 trillion. I suspect they’re not going to have any choice but to do more QE. But I don’t know what they’re going to do. I don’t know what the dollar is going to do. I can see a scenario where right now everybody’s bullish on the dollar just like they were back in 1999 – King Dollar.
So there are a lot of unknowns. I don’t know what unfolds in China. The geopolitical backdrop, to me, is incredibly uncertain, and frankly, quite scary. So I’ve always said this. Actually this goes back, watching CNBC, you get a lot of market commentators, and I would listen to them, and often they were so articulate and eloquent and I would say, “God, I wish I could be so confident.” But for me, the markets are so humbling, and I have enough scars from 25 years in the market where I try to know what I don’t know.
And I often say – this is an important part as a manager of people’s assets – my job is not to predict. It is to have a sound analytical framework, to work very hard to be on top of developments, to be able to react. And I think all of us need to appreciate right now, it is not investing, it’s speculating. We don’t know what the risk profile is, we don’t know what the future has to hold, and we’re going to have to react. There are going to be some major decisions that we’re going to have to make to protect ourselves, and to even profit going forward. It’s going to take a lot of focus, a lot of determination and hard work, and a lot of discipline to play this well going forward – a real challenge, but an exciting challenge.
David: Well, I hope you come off the sidelines, because it’s not a skill set that I think many people have, and something that I think many people would, in fact, benefit from. We are going to have to react, we’re going to have to stay nimble, and as you say, if you don’t bring humility with you to the investment markets, the market will provide it for you (laughs). It will give you plenty of it.
We thank you for sharing your thoughts with us. I can’t say strongly enough how important the Credit Bubble Bulletin has been for me this last decade. One, thank you for your weekly blood, sweat and tears that goes into that. I know the hours that it takes to construct an article 1/10th the size of what you produce. Not only is it prolific, but it is also very dense, in terms of the content that is put into it – worth every minute reading, and we would encourage our listeners to look at the Credit Bubble Bulletin and if you haven’t followed Doug Noland, to begin that process. It is well worth your time spending some time at his site.
Doug: David, thank you so much. Those are such kind words; it means a lot. The CBB has been a labor of love for me, and to hear you speak kindly is very appreciated. And you’re a blessing, what you’re doing. What I’m doing is nothing compared to your efforts and what you do for listeners and readers. Thank you for your efforts, and thank you very much for having me today.
David: Great to have you. Look forward to having you back.
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Kevin: Dave, that was quite comprehensive. If you had to summarize, or just come up with a single thought ending this program, what would you say summarizes Doug’s thoughts?
David: In Doug’s words, it would be, “Don’t be stretched out. You need to rein in risk, and now is the time to get your financial household in order.”