I finally broke an 8-week losing streak. After seeing negative portfolio returns every week since the beginning of February, taking me down 36.5% (adjusting the money I put in out of the gains), I hit a 2.1% uptick.
The reasons are obvious … my calls in TLT were absolutely killing me, while my heavy positions in gold, silver, and uranium miners weren’t helping. Last week I bought some falling knives in junior silver miners – particularly on Tuesday – and they rallied back hard by the end of the week.
One week’s performance means very little in the scheme of things, however. I need to focus on the longer term trends as I see them.
I saw an interesting link on Twitter yesterday with the article here: March Research Letter | Crescat Capital
This is what I really found intriguing: “It comes down to our primary macro call: long commodities and short equities, but especially long precious metals.“
I have found myself in a strange wedge here:
- I agree with the basic deflationary narrative of Steven Van Metre, Travis Kimmel, Lacy Hunt & Dave Rosenberg. Just like in Japan, the massive QE will not produce lasting inflation. To reflect this view I have long dated puts in EEM, IWM and long dated calls in TLT – betting on dollar strengthening vs emerging markets, US small caps going down, and long term interest rates rolling over and going back down. However, a number of these guys are bearish on base commodities and precious metals.
- I am quite bullish on the miners – particularly in Gold, Silver and Uranium but also in the battery metals like copper, nickel, graphite & lithium. However, this brings me in with the crowd who are crying out hyperinflation with a major US dollar collapse.
I was interested to actually see someone with a similar nuanced view who is both short major equities but long the miners. However, I did find that I disagree with a significant amount of his reasoning. Ultimately, he sees a re-run of the 1970’s or 1910’s and I really don’t think that’s what we’re seeing.
One big disagreement I have with Crescat Capital is their claim that we have had massive wealth transfers which actually led to gains for the bottom 50%. Most of the gains for the bottom were from two things: one time payments of a couple thousand dollars, and expanded unemployment benefits which only really helped the newly unemployed keep up with food and rent for several months. Both are short-term impacts. He also mentions that most of the gains for the bottom 50% are in housing – but the bottom half in this country don’t own homes and likely never will.
My view on deflation:
- There are major deflationary forces at work that greatly outweigh any of the deficit spending we are about to see.
- High debt levels require regular servicing – which pulls dollars out of the system month after month.
- High unemployment and the large fraction of temporarary/gig/part time work will keep a lid on wages so that price spikes in one area will merely result decreased demand elsewhere.
- As more boomers retire, their replacements are typically paid much less – if those positions are even kept open. Many of them retired early due to covid and those high-paying jobs won’t come back.
- Small family-owned businesses like restaurants, hair salons, travel agencies, etc. don’t have access to the excess capital in junk bond markets and such. Lending for them has been tight, and many have gone under permanently. This is devastating for an enormous source of middle class mobility and wealth.
- Politics are still dominated by fiscal conservatives. The stimulus bill that just passed took a party-line vote in the senate with the slimmest majority seen. A 50-50 vote like this can only work a couple times a year – they need 60 senators for most bills including the infrastructure bill in discussion. They started big so that fiscal conservatives can add taxes or cut spending to reduce the cost of the proposed infrastructure bill, but it is about to be whittled down considerably and it is still unlikely to get enough Republican support to pass. What they are fighting over now is at best the early projects of FDR’s new deal – which was also heavily opposed due to its cost.
- What will actually bring lasting inflation is when they stop fighting about the cost all together like they did on the outset of World War 2. Wars are HIGHLY inflationary because they create an enormous demand for all kinds of raw materials and energy while bringing many people into the paid labor force as soldiers as well as in many other industries. The big reason we saw the high inflation in the 1910’s was WW1 and the reason we saw it in the 1970’s was the Vietnam war. The creation of the federal reserve and the exit from Bretton Woods were merely tools in funding the war spending.
How the debt cycle generally works:
- Dollars are actually created by lending. The central bank cannot create money, they can only replace US treasuries on bank balance sheets with lower-paying overnight reserves to entice them to lend.
- The central bank can actually hit a hard limit on QE by taking all of the treasuries off the bank balance sheets and replacing them with zero-interest overnight reserve assets.
- Banks need to make money on their loans with interest. They can only lend to credit-worthy borrowers and these are becoming more difficult to find.
- In past cycles, reducing rates enough would create another investment boom. Projects that previously seemed too low profit or with cash flows too far out would suddenly start to work. Investments in non-productive assets like housing wouldn’t seem as much of a burden. Then then next cycle would start.
- We hit a problem with the zero-bound in interest rates. Low rates make it harder and harder for the banks to lend profitably, and negative rates make it nearly impossible. The federal reserve has been begging the government to create some spending because they banks are finding it difficult, dangerous, and unprofitable to lend more money into the real economy.
What happened in 2020:
- At the end of 2019, there was a yield curve inversion that signaled problems in the credit markets. The federal reserve responded by massively increasing their lending in the overnight repo market and all seemed to calm down. This action essentially reversed all of the previous balance sheet reductions in a fairly short amount of time. Tradeable markets responded by going up.
- In March 2020 we hit a major problem with the pandemic and lockdowns. Credit markets were freezing up, stocks were plummeting, margin calls were being made, and everyone was concerned about massive defaults.
- The US Government and Federal Reserve responded in a number of ways. They created a number of lending facilities as a backstop to corporate debt and even some junk bonds, combined with a large amount of fiscal stimulus.
- Banks were enabled and directed to massively lend into this environment. Massive QE gave them enormous amounts of reserve assets to lend against, while the SLR rule exemption was put in place so that they would just lend without worrying too much about leverage ratios.
- Banks responded massively in both the junk bond and corporate debt markets. In addition, they were able to ramp up another extremely profitable line of earnings – margin lending. FINRA Margin Debt (ycharts.com)
6. Money is created by lending. Margin debt began to increase dramatically across the board. Banks were encouraged to keep any lending growth moving. This led to massive inflation in the prices of tradeable assets such as US stocks and bonds.
7. Real estate lending – mortgages – were also highly encouraged with similar results. Not only did interest rates hit record lows, but telecommuting enabled a surge of people stuck in overpriced cities to move far enough out to buy their first homes. For the banks, most of these loans are guaranteed by the government, and even purchased by the fed to create reserve assets.
The above seems to fit a highly inflationary narrative – except that things are beginning to change. The Federal reserve became worried about the size of the stock market and housing bubbles on the one hand, and about the persistently high unemployment and lack of lending into the real economy on the other. They have long considered “Forward Guidance” to be one of their most effective tools, and they have been using it to encourage the “inflation” narrative.
Those “in the know” began to highly short the long end of the bond market in anticipation of a fed reaction to back this narrative. In February, a number of Japanese entities began dumping US treasuries for reasons relating to the end of their fiscal year creating a rout hit the US long bond. Interest rates on the 10 year and 20 year treasuries shot much higher and my long investments in TLT plummeted. Those short positions are still they have been reducing considerably. The stock market began to wobble, especially the tech-heavy NASDAQ, the many recent SPACs, and the big money losers dominating the Russell 2000.
Next, they decided to let the SLR exemption expire. This makes it more difficult for the banks to keep up their massive levels of margin lending.
Then Archegos Capital blew up. This hedge fund had extremely high levels of leverage, with margin lending from a number of different banks. Many of the holdings were large positions in relatively low-volume stocks such as VIAC. Goldman Sachs and Morgan Stanley started dumping these positions on the market the following Friday, and the share prices plummeted. Ironically, this liquidation actually caused a major ramp higher in the major stock indices because the fund was “hedged” with considerable short positions in them.
So what now:
- Banks need to reduce lending, particularly margin lending, due to the expiry of the SLR rule exemption.
- Banks just lost a bunch of money from a highly leveraged hedge fund blowing up with assets unable to cover its margin debt. This further incentivizes banks to reduce margin lending.
- Just like creating margin lending was highly inflationary in tradeable assets like stocks, a reduction in margin lending will be highly deflationary.
This will lead to a significant move lower in the markets. The main question is when. Many smart players are going to a larger cash position. So what should I do here?
I think that if a major selloff occurs, long-dated interest rates are likely to return to all-time lows. This will create a big payoff in my large position of TLT calls, as well as increasing the value of my long-dated puts.
So why am I still so bullish on the miners?
- As interest rates go back to all-time lows while genuine fear returns to the stock market, a lot of money will be looking for a place to hide and will find it with Gold.
- Sentiment in gold is pretty lousy right now and a lot of speculators have been shaken out at the trade, yet it has stubbornly pushed above the 1700 level quickly after every attempt to push it lower.
- The physical shortages of Gold in the system are very real, as are the number of unallocated gold bars with more than one owner.
- Gold miners are extremely profitable at current gold prices, with great cash flow.
- Miners of all types have received very little investment since the 2013 crash in gold, resulting in a long period with very little spent on exploring and developing new veins. It takes several years to get these mines into production.
- Silver goes up considerably when the sentiment in gold improves, and it is essential in many popular “green” applications such as solar panels.
- Uranium is similar but somewhat unique:
- Miners have gone through massive consolidations and closures since the Fukushima disaster in 2011 caused a collapse in demand following the many lengthy shutdowns of Japanese nuclear plants.
- Meanwhile, nuclear power remains the main way that large countries such as China and India can effectively reduce carbon emissions – and they have been building large numbers of new plants. A significant supply crunch is coming in this industry.
- The cost of Uranium is a tiny fraction of the cost of producing nuclear power, so the demand can drive up pricing substantially.
- The entire Uranium sector has a relatively small market cap, so any significant institutional investment would drive the miners up considerably.
Note that a major deflationary event could bring some downside to the miners, but I tend to think this potential downside is limited and they will bounce right back on the next fed/government reaction.
That pretty much sums it up. Here’s where my portfolio landed:
- DOWNSIDE BETS (39.8%)
- 32.3% TLT Calls
- 5.3% IWM Puts
- 2.3% EEM Puts
- GOLD (21.4%)
- 6.3% FNV, WPM, GOLD & NEM Calls (Large gold miners)
- 8.1% EQX (Small gold miner)
- 7.0% SAND Calls (Small gold streamer)
- SILVER (18.9%)
- 11.0% AG (Small silver miner)
- 0.8% AG Calls
- 5.1% SILV (Small silver miner/explorer)
- 1.2% MTA (Small silver miner/explorer)
- 0.8% RSNVF (Really small silver miner/explorer)
- COMMODITIES (15.4%)
- 10.1% CCJ shares (Uranium miner with covered calls)
- 2.0% ALB (Lithium)
- 1.7% NMGRF (Graphite)
- 1.6% NOVRF (Nickel/Copper)
- CANNIBUS (6.1%)
- 6.1% split between CRLBF, GTBIF & TSSRF (companies with significant US footprints)
- CRYPTO (3.0%)
- 3.0% split between ADA, LINK & LTC (Coins smaller than ETH that are in the top 10)
- CASH (-4.6%)