The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“We’re not exactly turning the corner in terms of demand pull. What we’re really turning the corner in is this over-abundance of debt with no buyers. We’re got rates that are moving up because the bond prices are moving down. Yes, I do see opportunities in the gold stocks. They are poised for a turn-around, as you know. In the last five to six years they have been tightening their belts, lowering their costs. This primes them for a very strong move to the upside, as gold starts to accelerate.”
– Dave Burgess
Kevin: We have some special guests today, Dave. It’s about time, actually, that you bring on the team that makes the decisions for McAlvany Wealth Management. We get so much insight from them on a weekly basis. I know Dave Burgess writes his weekly report, and of course, Doug Noland – what a team.
David: An in-house treasure trove is how I think of them. When I am looking for insights in a given topic, what we usually do is, as a group, hammer them out. We bring all of our ideas into a conversation and begin hashing out the details.
Kevin: I think the difference between an academic, Dave – we’ve talked about this before – and someone who actually is being tested by the market moment by moment by moment – there is a huge difference in listening to what their opinions are over time.
David: Dave Burgess started his investment career over 25 years ago with Nuveen Investments in Chicago. He was an analyst, and then a portfolio manager for about ten years, worked in the same capacities with Claymore Securities before moving to Durango and joining our company. Great to have him on the team.
Kevin: All that is impressive, Dave, but I’m most impressed with the fact that he almost went to the Olympics as a collegiate swimmer.
David: He is a fast man in the pool, that’s for sure. If ever you should see him with his shirt off, don’t be surprised by the gills (laughs) just under his arms right there.
Kevin: And then there is Doug Noland. Doug is a man that we have been reading for years. Jim Deeds, a guest of ours often, would call me and say, “Kevin, have you read Doug Noland’s Credit Bubble Bulletin this week? You have to.”
David: The Credit Bubble Bulletin goes back to 1999, and that overlapped his time where he helped Kurt Richebacher write the Richebacher Letter. As a credit guy, this is his area. He was a credit analyst with Toyota, working with Richebacher the same way. He spent nine years working in the hedge fund industry with Gordie Ringoen and with Bill Fleckenstein in Seattle, and then went for a 16-year stent with Prudent Bear Funds where he was not only portfolio manager but, ultimately, senior Vice President, head of Alternative Equities Management at Federated Investors.
Kevin: No offense, Dave, I hate to call you a head hunter – you’ve probably never thought you were one, but actually, you went out and head hunted this talent and fortunately, he said yes.
David: I’ll tell you the problem with growing a company like we have. It is finding the right people, because honestly, there are a million resumes that may read similarly, but there are only about two guys that I would say have the requisite character and fortitude, the requisite disposition to serve clients and always keep them first in what they do. And I think I’m surrounded by the best team imaginable – imaginable – and we’ll continue to grow that team, but again, it’s going to be one person at a time, and it just doesn’t happen every day that you have the quality of people, as well as the skill set matched to assist clients in their financial portfolio structuring.
Kevin: It seems to be a good team, a good match.
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David: Well, 2016 was a big year for our Wealth Management Group, Dave, starting with the announcement of a new strategy on the MWM platform, which you’ve been working on over the last several years. And then, in addition to that, merging with an advisory in Kansas City, Deeds Select Advisors, their key people moving out to Durango this year. Doug Noland, you’re joining our team as a portfolio manager, so basically, we’ve gone from having three robust offerings, to six. As often, frankly, as we have world-class guests on the program, sometimes we forget that some of the best insights and decisions are unearthed right here, right under our noses. So, thank you for joining me today and adding to those top shelf conversations.
Dave, you joined us 12 years ago from a mutual fund company in the Chicago area. You were with Nuveen for a long stretch. You also worked with Claymore Securities. At present, you manage four different account styles for us, one that I just mentioned. What would you say the greatest challenge is, managing money in the current environment?
Dave Burgess: I gave this topic a bit of thought and I could answer the question in any number of ways, but what stands out to me, what is the most important thing I think is, the leverage that we see in the marketplace today. The leverage is a function of those low interest rates. I think we’re at a 30-35 year low in the interest rate cycle. But knowing full well that at some point in time we are going to go through a different stage in that cycle where interest rates rise, therefore raising the discount rate, so to speak, to an overvalued stock market, a stock market that is trading right now between 20 and 30 times earnings, depending on the stock that you are looking at, which is also exacerbated, of course, by the internal leverage that corporations are using, most notably today through the share buy-backs, which most of them, I believe, are being financed through debt offerings and other things of the like.
Dave: But you now, raising the discount rate effectively has the impact of lowering expected returns. I don’t think the average investor buying stocks today is looking for a low return environment. They’re hoping quite the opposite. At least, that’s what the enthusiasm would have. But you’re saying, there is a natural consequence to raising interest rates, which is to lower your expected returns, and that really hasn’t been factored in yet.
Doug, you’re a specialist on the short side. To have a bearish inclination – that puts you in a group of about six similar people on the planet, (laughs) and it’s not quite extinction, but certainly bears are now on an endangered species list. I was thinking, in fact, that perhaps we could draw some attention to our new tactical short, doing a fundraiser with the World Wildlife Federation?
Doug Noland: (laughs) Isn’t that the truth?
Dave: Why do you do what you do, and what makes you so persistent?
Doug Noland: It’s true, I didn’t choose the easiest career path. Most investment professionals cannot see a market go against them 100% because markets can’t go to zero. But on the short side it’s a little different. I’ve seen the general stock market go up 300% three times during my career. When you see these periods – this last one lasted almost nine years – it kind of cleans out all the naysayers, it clean out people that were short, it cleans out the bears, everyone turns bullish. So, for me, those are the environments that create opportunity. I just love the analysis, I feel like 25-30 years ago I found my niche in life, and I wake up every day, even when the markets are difficult, it’s just a challenge and fascinating. I can’t imagine doing anything else.
Dave: And persistence. It takes a lot of it.
Doug Noland: Yeah, I’m probably just a strange guy when it comes to that because I’m kind of a small town kid from Oregon, I just love to work hard, I love independent thinking, and on the short side it gives you a lot of freedom to think independently. I can’t imagine working on the long side, especially today, where you have to be bullish. I can’t imagine the group dictating how I analyze and think about things. So, for me personally, this is perfect.
Dave: So, Doug, what is the MWM tactical short, and what makes it, in your opinion, a superior offering? Tell us a little bit about it?
Dave: Sure. Yes, I’m really excited about our new offering. Let’s go back to 1990. That was my first year on the short side. I worked for a bearish head fund manager out in San Francisco, Gordie Ringoen. The model back then was, we analyzed companies, and we knew the companies better than the longs did. We would put on concentrated positions, wait for them to work, and Gordie was phenomenally successful, long-term track record. We were up, I think, 63% my first year, 1990. Then the market environment changed, and what we had done for years didn’t work anymore.
So, that started, for me, this quest to build a better model for managing short exposure. I worked in the mutual fund industry for 16 years, I implemented a lot of changes to that old hedge fund model, do a lot of things in your portfolio to manage risk better, to have better liquidity, to reduce the overall beta of your portfolio, to change your exposure, depending on the market environment. And that was very successful. Those changes – it was a better model. We’ll call it a better mousetrap.
And now, this is the latest iteration, doing some tweaks here to the old model I had developed previously. In this model, a lot more flexibility to be less short if we need to be, generally, in this tactical strategy. And this is for separately managed accounts. These are transparent liquid accounts. We’re going to short stocks, sectors. We’ll short the general market. We’ll short other asset classes. We’ll be very flexible, and we want to be short where the best risk/reward opportunities are, and importantly, we’re going to be very disciplined with risk management and we’re happy to get out of the way if the environment is very unfavorable.
This is one of the weaknesses of the previous strategy I worked with – it was very difficult to capture gains. If the market went down and you had gains, you were still obligated. The mandate was still to remain short the market. We’re going to have more flexibility. If we’re opportunistic and have some good gains, we can really pull back our exposure and capture those gains. So, it’s a new product. We think it could be very successful long-term in the marketplace, and we’re excited to talk more about it.
Dave: So by tactical, you’re really talking about added flexibility to a mandate which allows you to not only pursue a variety of asset classes and sectors, but also the intensity of your engagement in shorting. You could be 100% short, or you could be sitting in treasury bills not short at all. You have the flexibility that you feel you need, which is something that has been lacking in previous iterations of short offerings.
Doug Noland: Absolutely. Flexibility, to be opportunistic, and to get out of the way of rapidly rising markets when necessary. So, that was very important when we conceptualized this product. We wanted a broad mandate that allows us the flexibility we think we need in very volatile, uncertain markets.
Dave: Dave, take us up to the 40,000-foot level. What are the significant shifts you see that have your attention right now? Are there any important shifts in the TIC [Treasury International Capital] numbers? Is it the incoming administration? Is it corporate America that has your attention with its revenues or earnings? What lingers in your mind when you go home at night?
Dave Burgess: That’s an interesting question, Dave. I would have to say that the number one thing that concerns me at this point is the TIC data. This is the Treasury data that concerns capital flows coming in from foreign creditors. This dates back to 1975 when we went off the gold standard officially and went onto the oil standard. From 1975, and accelerating through the 1980s and 1990s, we saw an increased amount of foreign interest in the dollar, or securities that are behind the dollar, that being treasuries, mortgages, corporate bonds, and equities, just to name a few.
The peak in foreign creditor purchases, I believe, was in 2006. I think at that time we had about – I think it was the peak of about 160 billion dollars a month of foreign capital coming here into the States in support of our dollar, keeping it elevated, along with certain securities. Most notably, of course, is the Treasury. That 160 billion dollars a month – 2006 numbers – has been tapering off, if you will, from 2006 until today. It has been up and down over the last several years, but it has been hovering in and around the zero mark now for, I would say, a year-and-a-half to two years, pretty comfortably.
So, what that means to say is, we have absolutely zero foreign capital net coming into the country. One of the big sellers right now is China. As you know, they have problems there in their marketplace, and they are trying to rectify issues by selling U.S. reserves to handle their problems. In any case, what this really means for the U.S. is that now we’re on a new grading scale – a completely new grading scale – such that if we don’t have foreign creditor financing, we are forced to seek it internally. As a debtor nation, I think we are running somewhere in the range of about 89 trillion dollars right now, which includes the shadow banking sector which isn’t talked about very much.
But if we intend on growing from here, we’re obviously going to have to come up with some stimulus, and that stimulus is going to be very difficult to acquire, or come up with, without adversely affecting, let’s say, the bond market, in this case, without that foreign creditor support. So, we’re going to be on the same grading scale, I think, as other nations that we have seen, whether it’s to compare us to, say, Brazil, Greece, Italy, or Spain.
But if we’re forced to search for internal sources of finance, it could be very difficult to come up with. I think it was since 2009, we’ve had about 3.8 trillion dollars’ worth of stimulus every year, on average. That’s includes 2015 and 2016 when the Fed wasn’t printing.
Dave: So, let’s say that the old world issue is foreign financing. The new world issue is, as you say, a new grading scale, we’ve got to move internal. Why don’t we say that the new world is actually a brave new world, and just assume that the Fed’s balance sheet can be expanded? I don’t know what the limits are. I think if you rolled the clock back ten years, you would have said that we can’t get to 5 trillion, and now we might say that you certainly couldn’t see 10, or 15, or 20 trillion on the Fed balance sheet. But if it requires internal financing, why not do that? Are the consequences so grave that you can’t consider it? Is it ineffective? Is that what we’ve seen in Europe? Why not embrace the brave new world?
Dave Burgess: I think the consensus view right now is that the Fed can do anything, that we’re bulletproof under their tutelage. So, I don’t think the future is going to be without an experiment, and that experiment would entail trying to print money to save the system. We’ve done it before; do it again. But when you’re printing money, and/or alternatively, borrowing money, to stimulate your economy, in tandem with other nations that are doing the same thing – remember, way back when it was really just Japan and the United States, Japan would print, we would borrow, it was yin and yang and it worked.
But now you have the ECB, you have China, you have the Swiss National Bank, you have Sweden, Russia. There are quite a few developed nations right now that are all printing at the same time. The big question is, of course, who is absorbing all that liquidity? So it becomes incrementally more difficult as we want to add to that currency pool, as we want to add to that debt pool, in order to finance our growth as we have in the past 10, 15, 20-some odd years. It is going to be more difficult to avoid the negative consequences that come with excessive amounts of borrowing and/or printing.
So, those negative consequences? Lower valuation for your currency, lower valuations for your bonds, higher interest rates. And to a debtor community, it’s going to be tough to grow in that environment because we need to borrow more money in order to grow, and it’s going to be very difficult to do at higher rates. So I think we’re in a stage right now where it’s slowly developing, but at some point in time, the dam will break and you will see the floodwaters, and we’ll start to see interest rates move up meaningfully.
Dave: Doug, as a bear, as someone who is willing to bet on declines in various markets or asset classes, what environment would be a real head-turner for you, where personal assets might leave a safe haven position and move into the markets, whether that is long equities, long bonds, long anything? What is compelling to you? Can you imagine that circumstance? Paint a picture for us.
Doug Noland: Yes, sure, I can imagine that circumstance. I’m very outspoken. I think this is a historic bubble. We’re at the late stage of a bubble that has been going on, really, for decades, and when this bubble bursts I would like to be opportunistic and buy things at a good price. But right now, as Dave mentioned, interest rates are historically low. We’ve been at almost zero interest rates, bond yields have been extraordinarily low, and you’ve also had this backstop in the market. The markets believe if there is any problem the central banks will step in to make sure there isn’t a bear market. Well, if we could see a different environment where prices were determined in the market, not by central banks, I would be happy to be an investor. We’re a long way from that right now, though.
Dave: So, maybe with that in mind, you could simplify and shrink your investment thesis to the present tense, where you are cautious and bearish. Shrink down your investment thesis for our audience. Actually, if you would, just kind of assume you’re talking to my kids (laughs). You have a present tense backdrop – that’s important. But how do you demonstrate, theoretically, where we are now, and the moves that need to be made in the future, as well? Is this simply a question of value?
Doug Noland: Throughout history, we have had so many monetary inflations, but that doesn’t mean anything to your kids, so I won’t explain it in that way. But what we’ve done is, we’ve created all this new money and credit. For this example, we’ve created all this money, and it works well until, for whatever reason, you can’t continue to create new money. That might be inflation, or it might be a crisis of confidence in the underlying value of that money. You can only print so much of it before people start to question its value. I look at equities and risk assets and I don’t really look at them from a value perspective, but I definitely look at money from a value perspective. You can’t continue to have central banks and governments create all this new money and for the markets to always trust it.
That is what it will come down to for me. At some point in the bubble there will be a crisis of confidence. We saw how this can work in 2008-2009, and I fear the next crisis of confidence will be even greater. Why? Because during this cycle, over the last eight or nine years, we have printed so much money, unlike anything in history. I say print – these are basically just electronic debits and credits, just electronic entries out there, and at this point the market believes all those entries are backed by wealth, but at the end of the day I think they will question that faith.
Dave: Dave, wealth management is literally in your blood. You have several generations of investing and seeking out stable value. That’s what is behind you, and I have to say that you’ve learned, you’ve grown, you’ve even raised the bar, from one generation to the next. I witness your daily commitment to your responsibilities, the disciplines involved, and it’s an effort (laughs) not unlike your professional swimming career. I thank you for shifting your wardrobes when you changed your career. What it requires is daily discipline. And I’m curious. What has surprised you in recent years? And you pick your choice – either evolved, positively, or devolved, in the markets, say, in the last five years – what has been the surprise?
Dave Burgess: I’d have to say that what has evolved is the access to information, I think, is exemplary. It’s great. I can find information on just about any sector that is out there, analyze it thoroughly, at least from a macro perspective. So, the access to information is remarkable. It is just that what has devolved is that the information isn’t always useful. We live in a world where we’re printing money out of thin air and that money is applied to the marketplace, so where there is sort of this artificial prosperity.
You bring up the word discipline. I would say that we have a lack of discipline in the marketplace at this point, because who needs it when we can print money out of thin air and do whatever we want with it? I can look at the data, and I’m sure Doug can attest to this – you can have the data sitting in front of you, and the charts will tell you that the market is ripe to do this or that if it is overvalued. And then you wake up the next morning and you realize that the market doesn’t care, and that’s really in a world of printed money, free money.
So, discipline will return to the industry at some point in time, as we’ve been talking about. Interest rates will change, I think, and everybody will have to go back to work and really do their due diligence, credit risk, per se, when it comes to analyzing a stock and/or a bond, or any security for that matter.
Dave: That’s true. In a period of easy money hard work isn’t necessarily rewarded because the investment world becomes more casino-like. That means that participants benefit from gambling, not necessarily thinking and analyzing risk.
Doug, I’m curious. We have this idea that inflation, at least, the official statistics, have turned a corner, appear to be turning up a bit. And we’re also shifting from monetary policy to fiscal policy moves. We’ve slowed down on the monetary policy side and appear, with a new administration, to be ramping up on the fiscal policy side, which may suggest that there is a resurgence in inflation during the next two to four years. How does the shift in focus from deflation of the last eight to nine years, to inflation over the next several – how do you anticipate that altering the current asset price landscape?
Dave: I think it’s a key shift. I think 2017 is an inflection year. You can pull up inflation charts in Asia, Europe, even here in the U.S., and it points up now. It has pointed down for a number of years, and while it was pointing down that gave a lot of flexibility to central bankers, where they could justify, rationalize QE, saying there was very little inflation risk. So, you could err on the side of printing money and inflating stock markets. I think those days are over now. I think central bankers will have to think twice before they resort to more QE. So that definitely changes the risk/reward calculus and risk assets. The rising inflation and the higher risk in securities, I think, increases the attractiveness of gold and precious metals. So yes, I think key changes we’re starting to see in the marketplace already this year.
Dave: Dave, I’m curious. You’re on the phone quite a bit with prospective clients, and once the market is closed and your portfolio management hat is off, describe a recurrent conversation with clients. Someone who is exploring the idea of opening and account – what are they concerned with? What is on their mind right now?
Dave Burgess: Most people that come to us have a full portfolio of stocks and bonds. They have full ownership. They’re exposed, per se. And behind it, typically, there is an organization, or perhaps even an individual, that carries with that portfolio a certain kind of blind naiveté with respect to the markets. A client, in this case, knowing something is wrong. They just have a feeling something is wrong in this environment, either from the endless streams of prosperity, with the market being up, as Doug mentioned earlier, 300% two or three times over his career. They know the music is going to stop at some point in time and they want to go with an organization, or an individual, that at least has some sobering viewpoint with respect to the risks inherent in the marketplace.
So, if I’m going to say anything at all here, it is, they’re looking for continuation in the ownership of America – ownership in companies, ownership in people. There is a certain amount of pride that goes along with that. But they want insurance. And if we’re going to define insurance, here, it is protecting something of value.
So, we could talk about insurance, and I don’t want to belabor the point, but we’re getting into an environment where even the insurance costs quite a bit in this environment.
Maybe Doug can comment on this as well, we’re looking at natural hedges in a portfolio, without the use of leverage, where we can, of course, to hedge a person’s stocks and bonds in their portfolio, and gives them that sense of comfort, knowing full well that the wind will shift in the marketplace and they’re going to be protected from that kind of downside.
Dave: So, staying close to – if you could call it market neutral, while owning high quality – that’s sort of the balance that you want today.
Dave Burgess: Yes, market neutral in terms of our ownership. When you say quality, we’re still looking for names that are out there are positioned to benefit from, or at least can survive much better, relatively speaking, with other companies, in times of inflation.
Dave: Speaking of inflation, gold will, at times, when you have a shift in inflation expectations, pick up a bit. And gold stocks tend to do the same. Should we see an inflationary concern re-emerge? Do you think we’ve turned a corner? Do you see price action in those spaces that would indicate maybe 2015 was the low and we’re kind of in the clear? What are your thoughts?
Dave Burgess: I do. I think we have turned the corner in the gold market. I think calls for $1,700, as you hear from various people out there, are a little overblown at this time. Inflation is on the move and I would say, I think one of the major contributors to the inflation stats that we have seen – 0.6% rise in the PPI, 0.6% rise in the CPI, which I think equates to somewhere around 7.2% annualized – big numbers for January.
What is contributing that, I think, is the significant rise we have seen at the short end of the curve, as well. I don’t know about the six-month paper, or the one-year paper, but the two-year paper treasury note has risen about 60 basis points. This significantly increases the operational costs of many companies that are out there, particularly manufacturers. So, yes, inflation is on the move, perhaps not in the way that we would like because we normally call it a demand-pull inflation. I think this is more of a cost-push, demand being that consumerism is picking up, as you have spoken of before on this show.
But I don’t think that is the case. I think with the results that we have seen in retail sales, being somewhat mediocre, with the benefactors being kind of random – Amazon doing well, Walmart doing not so well – we’re not exactly turning the corner in terms of demand pull. What we are really turning the corner in – it goes back to, again, this over-abundance of debt with no buyers. We have rates that are moving up because the bond prices are moving down. So, yes, I do see opportunities in the gold stocks. They are poised for a turnaround, as you know. In the last five to six years they have been tightening their belts, lowering their costs. This primes them for a very strong move to the upside as gold starts to accelerate.
Dave: A month or so ago I was highlighting the difference between what we need to be supplying the market, to keep stasis. About 90 million ounces a year is what we need to be finding in discoveries and bringing to market, and we’re in the 10-15 million range. So, kind of interestingly, if we are seeing a turn in the price, and that is an indication of increasing demand, we’re going to experience a little bit of a supply crunch because of under-investment in new exploration projects over the last five to six years as companies have had to tighten their belts and cut exploration budgets.
Doug, on a different subject, you have worked with small firms. You have worked with very large firms. What do you hope to accomplish with our firm and the rollout of the tactical short at the beginning of Q2 here in early April, just around the corner.
Doug Noland: Sure. David, you’re a wonderful person, and you lead a wonderful group of folks here, so I’m honored to be part of it. I guess I’m at the stage of my career where I’ll only work with people I admire and trust, and that I would go to battle with. I found that here, as far as our product. I have also come to believe that if you’re going to run an alternative investment strategy, you really can’t do it at a big firm. It just doesn’t work. The big firms don’t nurture independent thinking like the small firms. So, we’re going to use our independent thinking and our unconventional, contrarian analysis, and put together a new product.
And what are we trying to accomplish? I just want to put together a tactical short product that makes sense to investors. And then I want to make sure it’s successful. And I want to build something that is around 20 years from now. And it’s all about a strategy, a philosophy, and executing a challenging strategy, but executing it every day. And trying to create value for our investors in what will be, I think, an unstable environment.
Dave: Tell us about a conference call coming up here at the end of March.
Doug Noland: Yes, that will be an opportunity for us to give some more details. I will certainly delve into the investment philosophy we have, get somewhat granular into our investment process that I think is very important, and we will talk a little bit about the global environment, the U.S. environment. I think I will try to make a case that 2017 is an inflection year, that it is time to refocus on risk after really not having to worry much about it for eight to nine years. And then we will take a lot of questions. Hopefully, we will get some good questions. I think we are going to set it up where folks can email in questions and I will go down the list and try to answer them.
Dave: Gentleman, I’m grateful you are both on the team. 2017 promises to be a fascinating chapter in investment history and I’m glad we’re working shoulder to shoulder together on behalf of our clients. Thanks for joining the conversation today.
Dave Burgess: Thank you. Appreciate being invited.
Doug Noland: Thank you very much.