Guests: Kevin Smith is the founder and CIO of Crescat Capital. He has been the portfolio manager of Crescat’s three investment strategies since their respective inceptions. Prior to founding Crescat, he worked as a financial advisor with Kidder Peabody. Tavi Costa has been an analyst on Crescat’s investment team for more than five years with a focus on global cross-asset research. Tavi built Crescat’s macro model that identifies the current stage of the US economic cycle through a combination of 16 factors. His research has been featured multiple times in financial publications such as Bloomberg.
Date Recorded: 4/12/19 | Run-Time: 54:48
Summary: Kevin kicks off the conversation with an overview of Crescat’s approach, the long-only strategy, long/short equity hedge fund, and Global Macro Fund. Tavi then gets into high equity market valuations, their macro model that has timed well in backtests with previous market peaks and troughs in the tech and housing bubbles, 15 countries with 30-year bond yields below the Fed Funds rate, and demand for U.S. Treasuries and the U.S. dollar. Kevin follows up with some comments on implementation and expressing these views in their portfolio, and why they continue to trust their process and remain net-short equities.
Next, Tavi gets into Crescat’s thesis on China and the potential credit bubble, and the vulnerable Chinese currency as a result. Meb then asks about Crescat’s bullish thesis on precious metals. Kevin discusses that trade’s role in the portfolio, and its place as a theme in the global macro fund, which includes, a short equity theme, long precious metals theme, and a short Chinese Yuan theme. Meb asks the pair to get into some of their other themes that stand out as opportunities. Kevin links the Canadian housing bubble and Australian debt crisis themes to China and Chinese capital outflows. He also covers some longs as part of their cybersecurity theme such as Palo Alto Networks.
Meb shifts by asking about what investors should takeaway from Crescat’s thinking, Kevin adds that people should think about more tactical asset allocation, become increasingly defensive, and consider some alternatives. Tavi adds that investors may want to consider cash, precious metals, and perhaps some Treasuries.
As the conversation winds down, Meb asks about anything else they consider that isn’t covered widely in the media or by investment managers. Kevin discusses consumer confidence, and Tavi adds twin deficits and an alternative view of beta.
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Links from the Episode:
- 0:50 – Welcome and introduction to Kevin Smith and Tavi Costa
- 1:21 – Origin story of Tavi and Kevin, and how it led to the formation of Crescat Capital
- 3:24 – Crescat’s view of the world today
- 6:07 – How do they look at valuations
- 9:11 – How they express timing factors in their investment strategy
- 11:42 – Thesis on China
- 17:17 – Trade catalysts
- 19:26 – Chance of an orderly wind down
- 24:19 – Why precious metals are an interesting area for investment
- 25:45 – Comparing precious metals to the underlying equities
- 26:35 – Interesting areas they are examining
- 31:18 – Strategy for implementing their ideas
- 33:19 – Bubble in utilities
- 34:34 – Battle of Safe Havens
- 35:32 – What people can take away from their thinking
- 41:29 – Factors that may be less known or used incorrectly
- 46:12 – Anything that gives them pause when it comes to their investing thesis
- 48:35 – Most memorable investment
- 53:48 – Connecting with Crescat: http://crescat.net/, email@example.com, twitter; @crescat_capital @crescatkevin @tavicosta, YouTube
Transcript of Episode 152:
Welcome Message: Welcome to “The Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com
Meb: Welcome, podcast listeners. We have an awesome show for you today. It is Friday, April the 12th. We got two people. Kevin is the founder and CIO of Crescat Capital and is behind the firm’s global macro investment process and systematic equity valuation model. Tavi serves as a global macro analyst and has been on their investment team for over five years with the focus on global cross-asset research and has built Crescat’s global macro model as well. Welcome to the show, Kevin Smith and Tavi Costa.
Kevin: Thank you, Meb.
Tavi: Thank you, Meb.
Meb: So, fellas, it’s great to have you here today. You had one of the better performing hedge funds of 2018. I would love to hear…for those particularly who aren’t familiar, walk us through a little on Crescat, your origin story. And there’s two of you, so I’d love to hear you guys sprinkle in, feel free to add a little personal background, too.
Kevin: Sure. This is Kevin. And my background, I have an undergrad degree in Economics from Stanford. I went to business school at the University of Chicago after a stint at a public accounting firm for a few years and got into the business with Kidder, Peabody as a high net worth broker. So my background is really with a high net worth client base that I’ve maintained over the years. And took a job after Kidder with a local brokerage firm here in Denver, where I started an asset management division for them. And that’s kind of where my first product started, our large cap long-only strategy, which has got about a 20-year track record now, and a long/short equity hedge fund that I started there as well.
I started in Crescat in 2006. And that was to launch a new strategy, our global macro cross-asset strategy that we’ve had since 2006 and moved a lot of the clients over from the other strategy, so was able to continue those strategies as well in the track record. That’s just kind of a brief background on Crescat. Tavi joined me about five and a half years ago. Tavi, why don’t you give a little bit about your background?
Tavi: Sure. So I originally…born and raised in Brazil, I guess, and moved to the U.S., recruited to play tennis in college back in the days, and moved to Liberty University. You know, I played there for a bit, then I moved to St. Lewis for a private school, finished up college there, moved to Colorado, start working for Kevin, and now I’m just more focused on the macro part of it. I’m usually the guy behind most of the modelling of macro research and just in general of helping and managing the portfolio. So I guess my introduction is a lot shorter than Kevin, but I’m still young, but, [inaudible 00:03:22].
Meb: So, look, you guys put out a lot of great research. Some of it is contrarian, but not always, but thoughtful in different ways. And we’ll eventually get to one of my favourite headline pieces you had, which is where you guys talk about the macro trade of the century. But why don’t you guys give us a brief overview of y’all’s framework, for how you think about investing? Global macro means a lot of different things to a lot of different people. So how do you guys think about the world? And maybe we can start out as a jumping-off point to talk about kind of where we are, what does the world look like today. That can mean economic cycles, markets, and we’ll go from there.
Kevin: We view the world through a little bit different of a lens than a lot of other macro shops, given the equity background that I told you about, really starting off with a long-only equity strategy that was a quant fundamental value-oriented type strategy that I…and the equity quant model that I developed behind that more than 20 years ago, and then the long/short equity hedge fund, applying that same model to both longs and shorts.
But really what developed out of that over the years was that our models were really guiding us more to bigger picture themes in addition to being able to select individual stocks. Bigger macro themes, like in ’06, ’07, we had the housing bubble theme, and we were short mortgage companies and banks, and we were short Lehman Brothers and Bear Stearns back then just based on our model and this housing bubble theme that we had developed.
When we launched a global macro fund, it was really to have that long/short equity portfolio be a part of it, but also to have bigger macro themes and be able to trade across other asset classes: commodities, currencies, interest rates, and so forth. So that’s kind of the evolution of how we think. And we really started developing more macro models as well three or four years ago more intensely above and beyond just the equity quant model that we have, and that’s how we view the world. Tavi, you got something to add to that?
Tavi: No, I think that it’s mostly… We do a lot of aggregation of macro fundamental data, creating systemic models, but it’s mostly a discretionary shopper. We just use the models to help us to guide on coming up with ideas. And I think the three highest conviction themes in how we see the world today, number one is essentially we think that U.S. stocks and global stocks in general, but mostly U.S., are historically overvalue for several factors that we can mention later here. The second one would be the China being a historic, perhaps the largest credit bubble we’ve seen in history, which is in line with macro trade of the year. And the third one would be long precious metals and more of why we think precious metals could be the perfect safe haven for the turn in the cycle here that we think it’s already kind of started.
Meb: That’s a great lead-in. Let’s take those suckers one at a time. Let’s start with valuations. How do you guys look at it? What are the indicators? Anything looks good? Are you short at the world? What’s going on?
Tavi: Everything started with…we start looking at valuations and realised that valuations are historically high in several indicators, one of them being…we mentioned eight of them on previous ladders and price-to-book and EBITDA-to-sales and price-to-sales and EV-to-EBITDA, cyclically-adjusted EV for cash-flow adjusted, CAPE ratio, market cap to GDP. All of those are above the 90th percentile historically. So that really drove us to, you know, think about adding some other economic indicators to overlay the research and some technicals, and that was really the creation of the macro model that we put out.
That macro model combines 16 factors. It’s a much simpler version of what I just described. And the 16 factors is economic indicators, fundamental data, and a few technicals. And the score goes back all the way to 1987. And realise the score today is about two percentage points away from record overvalue levels. And when you back test that model, we also realised that it timed perfectly the previous market peaks and the attack in the housing bubble and also timed very well at the bottom of those two markets. And this is not just one factor that we looked at. This is just obviously one part of the research. And that kind of drove us to look a little further and start thinking about what we see the world.
The second thing is kind of lining up all those macro indicators, which started by looking at 30-year yields in several countries in the world today. And we realised that 30-year yields are actually lower than Fed Funds rate, which is an overnight rate. And actually that problem is happening with 15 economies today. And New Zealand just joined the pack last week or a few weeks ago.
When you line that up across all the way back to 1994 or so, what you see is that that distortion tends to reach an extreme every time you’re at the peak of a cycle. And what’s unique today, though, is the amount of countries showing that imbalance. And that has a lot of meanings in general, one of them being a global yield curving version problem, which is negative for stocks, obviously. And the second one would be what we see as perhaps demand for treasuries just because of U.S. rates relatively high when compared to global rates in general. And the third one would be the dollar, you know. That essentially drives a dollar to rise. It makes sense to be for the dollar… What you’re gonna find is that, obviously, where we have a view on the dollar, but we also have a view on gold. And they don’t go against each other, actually, but we’ll elaborate on that.
Kevin: The 16-factor macro model that we have, it combines both evaluation indicators and kind of length of the business cycle and timing of the business cycle indicators, so that, you know, about 12 of the indicators are really more macro timing type of indicators, and maybe just 4 of them are the valuation indicators, even though Tavi ticked off about 8 valuation indicators that we think are near highest ever.
Meb: So how do you guys express that? So, you know, as you look around the world, is this something that you say, “Look, I’m just gonna take a backseat. I don’t wanna be invested in equity markets?” Or you say, “No, we wanna balance it long and short,” or “No, we’re just short everything?” And then also, secondarily, like, how do you incorporate timing of this trade into your thesis?
Kevin: We’re a tactical global macro shop, and our hedge funds have been net short equities for really two years now. That hurt us in 2017. We were clearly too early. Being focused too much on the valuation indicators, not enough on the timing indicators, was the problem. And that’s really when we developed this whole macro timing model above and beyond just the valuation indicators to get a better sense of are we really at the peak of a business cycle and record overvalue the way we think we are. We developed the model. It told us we’re in the 100th percentile for record overvalue, record late cycle, back in 2017. And it gave us a conviction to stick with that net short equity position in both of our hedge funds. So we are pretty much grounded in our macro views in terms of how we express it in the portfolio.
It was tough going into January of 2018 when the market was still raging higher. We had it down a year, we were down in January, in both of our hedge funds. And then February came on, Volmageddon, and we had a huge month, and we were right back on track. And then over the course of the rest of last year, global equity markets really peaked out in January of last year, and that was… Most of our equity short positions are not just U.S. You know, we also have a lot of China-related positions, other housing bubbles, where we’re short banks, like in Canada and Australia.
At any rate, when emerging markets really started to falter in June, we had some other big months, and then finish really strong in the fourth quarter just by staying net short according to our models. And now, obviously, you know, it’s hardest, and we’re having a pullback year, and so far, a year today, because we still continue to be net short. But you have to ask yourself, was the fourth quarter the beginning of the bear market, or this first quarter really more like a bear market rally, or is this business cycle going to continue? And I really believe that the fourth quarter was more like the beginning of something in our favour. And so we’re willing to stick with our models and our views, and we’re staying that short. We believe we are in the early stages of bear market.
Meb: You mentioned a pretty big gravitational force, which there’s been some pretty strong opinions on each side, and that being China. You know, a lot of people have lined up as extremely bearish, others extremely bullish. Why don’t you guys walk us through your thesis, what you’re thinking about China, as I know it’s a major driver of kind of how you guys think about a lot of things globally?
Tavi: Essentially, it all started by looking at the big picture of global debt and imbalances that we see in the world today. And we were looking at the past largest credit bubbles we had in history over the last 30 years all the way back to Japan in the 1990s and the Asian crisis and housing bubble and so forth, and European debt crises, too. And if you look at that, the average of the total debt-to-GDP ratio of those imbalances were close to 245%, 250%. And today in 2018, or today is 2019, but 2018, the most recent number for total debt-to-GDP and the largest ratios in the world today, that average is close to 269%. And again, this is just a big picture. It’s not a timing indicator. We’ve realised this, if you look back in 2017, ’16, you would still see this massive imbalance. But we wanted to dig in and see what was at the centre perhaps of some of these imbalances and not the answer for all, but at the centre of it. And perhaps it’s China.
And we found that China, we calculated on-balance sheet assets of Chinese banks relative to GDP, and what we found is that it’s much higher than it was in the U.S. housing bubble and the European debt crisis in 2011. It’s above the 300% range. And that doesn’t include what we see as the off-balance sheet assets, which they admitted to in their financial stability report that they put out every December, and it’s somewhere close in under $45 trillion of off-balance sheet assets.
So we’re looking in a very conservative way by just looking at on-balance sheet, and the growth of assets, you know, all the way back to the global financial crisis is close to 400%, you know. That completely dwarfs places like the U.S. and Japan and Eurozone going back to those times. And you got to think about what’s the consequential damage of all this that build up throughout all these years of China. And we think that it’s the Chinese currency that is likely to suffer and depreciate against the dollar.
There is research that we put out that was kind of interesting. There’s a lot of factors. I’ll give you a few on this. But we looked at the change in current account in multiple countries from the global financial crisis to today versus the change in currency value during the same period. And what you find, first, you find Argentina being your outlier. The current account of Argentina shrank significantly during that period, and at the same time, the currency devalued close to 90%. But then what you find is this quadrant of currency devaluation risk, which we see China, Hong Kong, Saudi Arabia. Again, it’s just one factor.
But what’s interesting is that China is the only country in the world that its current account actually shrinked significantly since the global financial crisis, and at the same time, its currency actually appreciated against the dollar. So we think that that’s kind of interesting. It’s perhaps an imbalance. And also, what you see there, Hong Kong is, you know, all those three countries that I just mentioned, are all peg currencies. And obviously, Hong Kong is another one that we have a strong opinion against the Hong Kong dollar as well, but that’s not the only thing. What we hear most people saying is, well, you know, the PBOC got their back. And essentially, they’re just gonna stimulate the economy. They’re never gonna really stumble into a contraction and economy in China. And maybe that could be true in some way.
And one way to look at the Chinese currency as well is just looking at, if you look at the required reserve ratio of major banks in China today, and you line that up with the Chinese currency, they follow each other remarkably close all the way back to 2000s. And more recently, there’s kind of an alligator mouth of Chinese currency actually appreciating at the same time, and its deposit reserve ratio, it’s actually being reduced twice this year already. So we see that as a kind of an alligator mouth and perhaps a great setup for us to be short the currency right now.
Kevin: The market expects China to drop its reserve ratio another three times throughout the rest of the year as well, something I just ran across this morning.
Tavi: The other part of it, too, is look at the correlation between Chinese stocks and the Chinese currency. It’s at the highest level. One way to look at it is looking at the 52-week rolling correlation of the two assets. And what you find is that it’s the highest positive correlation in history all the way back to 1990s.
And then it’s interesting because we think that that relationship is really unsustainable, because, well, first, it started with both declining in 2018. That was really kind of the reason why the correlation started to get strong. But it’s more recently that the spike really caused the correlation to rise, it was because of both going up together. And so we think that, you know, if China, in the fourth quarter of 2018, the median stock in China was down close to 40%. I don’t know any country in history that has had such a situation and that was in a bad picture economically speaking.
So essentially, China now has been stimulating somehow through the PBOC and so forth and different channels of liquidity intervention. That should have an effect on the currency at some point. We’re gonna stay grounded and still keep our negative views on the currency.
Meb: What do you see is the challenge for so many of these trades? What is the catalyst? I mean, they’re often obvious in retrospect. So many times, fragile markets or systems, it’s not necessarily needs a catalyst. But is there one that you think that kind of triggers this as far as with regards to China and its effect on the rest of the world?
Kevin: It’s hard to say what exactly the catalyst will be. Because if we knew what the shock was gonna be, it wouldn’t exactly be a shock to the world, yet there are so many possible things that it could be. When you look at the markets in general today in this rip-roaring rally that we’ve had across global equity markets, and China being one of the leaders here year-to-date, there’s a lot of hope over things like the trade deal and over the Fed pausing its interest rate hikes. There’s a lot of hope over… There’s narratives going around that stocks are still cheap. They’re reasonable on a P/E basis, which is what we go out of our way to dispel here. But there’s a lot of hope that’s driving things right now.
It could be something with the trade deal going awry. It could be something with capital outflows in China, some kind of real estate housing crisis within China. It’s really hard to say where the shock is going to come from. You know, something, you know, already with the Fed’s interest rate hikes of 250 basis points over the last 3 years, we think, is already putting tremendous pressure onto China. It’s hard to say exactly where it’s gonna come from, but if I had to bet on something, I would bet it comes from some kind of disappointment with respect to the trade deal.
Tavi: What’s interesting about this stuff on the trade deal is that, I don’t see a lot of people talking about this, but if there’s an agreement or a disagreement between China and the U.S., that would still result on a net decline of China’s current account balance, which, you know, I can’t really see how China could sustain such an indebted economic model for too long with the current account turning negative somehow. I don’t think that’s really being priced in correctly in the market right now.
Meb: What sort of oddsmaker chances do you give this of unwinding in an orderly fashion? Is this something that could just kind of go sideways for a while? As a macro shop, always trying to think of the other side of the trade, what sort of odds do you guys give this being an orderly wind-down?
Kevin: It’s not what we’re used to seeing in economic cycles, and particularly given the imbalances that we have today, and yet, you know, I think China has gone out of its way to try to show the world that things are orderly, that their currency can be managed in a tight range, that they can pull out all kinds of fiscal and monetary stimulus to keep the economy growing.
One of the things that we really think could lead to disorderly at a bust is global liquidity today is the shrinking of the Fed’s balance sheet already over the last year and a half or so and the rate of change in global central bank assets, because of QT in particular, and the global M2 rate-of-change growth. We put out a chart just a week ago or so that showed that when you look at both global M2 growth and the rate of growth of central bank assets, they both went negative on a rate of change basis year over year. And that’s the first time we’ve ever seen that in this business cycle for sure.
And people think that because the Fed has paused that it’s a bullish sign. And normally, when the Fed pauses, or in particular, when they reverse their monetary policy late in the business cycle, it’s not a positive sign at all. It’s a response usually to a crisis. And so I don’t know. That’s just something else we look at.
Tavi: In line with that thought, I mean, one way people can see this, especially looking at credit markets, is looking at the two-year yield. If you look at the U.S. two-year yield, and you log that chart, you know, all the way back to, I think, goes back to the ’70s or so, you can kind of draw this multi-year resistance line. And every time the chart, this line, kind of touches this multi-year resistance line and the two-year yield begins to fall significantly, we’ve been in the turn in the business cycle to recession. That happened in a wait and the tech bust and all the way back to that double-dip recession in the ’80s. And so, you know, we think of it as be wary of when credit markets start to price in. The Fed is gonna have to cut rates, you know, very late in the cycle. So I think that’s in line with Kevin, I guess.
The other thing we did, looking at credit markets, I thought was interesting, is there has been a lot of attention on 3-months versus 10-year yields recently with the inversion a few weeks ago. But, you know, we looked in a much more comprehensive way. So we built this model that looks at all the 44 possible spreads in the in a yield curve in the U.S. It looks, you know, percentage of inversions of the yield curve. And what you find in this chart is that above 50% of the yield curve in the U.S. is inverted today. And it’s just as high as it was at the peak of the housing in the tech bubble. So, you know, looking at that, I mean, it’s kind of hard to see how credit markets are not clearly pricing in what seems to be a recession, inevitable recession, in the near term, at least to us.
Kevin: At least, an inevitable bear market, you know, leading to a recession.
Tavi: That’s right.
Kevin: And, you know, we think the bear market has to come first. And a lot of people are citing some crazy statistics with respect to the yield curve inversion. And the average yield curve apologist out there today, you know, says, “We have two more years of great times now.” And, you know, they’re not looking at the whole picture. I mean, ’73, ’74, 1969, I mean, ’73, ’74 in particularly, the bear market started six months before the yield curve inverted. ’69, it started immediately as the yield curve inverted. 2000, that bear market started immediately as the yield curve inverted. And so this idea of you have two years, you know, it may be coming from averaging in one or two possible fall signals.
And, of course, 2006 is the elephant in the room there, because in 2006, yes, it took two years before the recession hit. But guess what started in 2006? That was the peak of the housing bubble, and the yield curve nailed it. If you were short home builders and mortgage stocks in 2006, you crushed it, because those stocks peaked out in late 2005. And, you know, and shorting banks starting in early to mid-2007, you know. So waiting for the recession to come, to turn bearish, is a really bad idea.
Meb: So as you guys talked about, there’s kind of three legs to this trade stool, the third being precious metals. And precious metals are something that, man, they’ve been quiet for a long time. And the media has been pretty quiet, which usually is a good thing. Walk us through why you think that’s an interesting area for investment?
Kevin: We have a lot of reasons to people who shun on precious metals. We think we’ve been through, depending upon how you count it, either a five or a seven-year bear market, particularly for the precious metals, mining stocks. And when you look at the macro timing indicators of yield curve inversions, for instance, and go back to the past two cycles, in 2000, when the yield curve first inverted, looking at three and five-year yields versus the Fed Funds rate, when they inverted in 2000, and again, in 2006, that was when the gold to S&P ratio really started to take off.
And if you just look at it in this way, you don’t have to be a gold bug, you don’t have to try to even value gold stocks, you know, just look at the macro timing signals of when to buy gold versus the S&P, from 2000 to 2002, the gold to S&P ratio went up 200%. And then from ’06 to 2009, it went up 300%. But we have a number of other valuation indicators that we look at, too, that make gold attractive to us.
Meb: And how do you make the distinction between the precious metal and the underlying equities? Is it something you treat as two different buckets? You compare them to each other as fine one that is more attractive, or you just put on the trade and do both?
Kevin: We look at them each individually as an investment in and of itself. We also… If you think of our portfolio and our global macro hedge fund, you can think of it as three major overriding themes: a short global equity theme that’s largely tilted towards U.S. equities, a long precious metals theme, and a short China yuan theme. And, you know, that’s kind of our macro trade of the year, if you will, is short global equities versus a long gold in China yuan terms. But each of those three legs really can be viewed on its own, you know, where the whole thing could be viewed in terms of a portfolio.
Meb: You guys have a lot of other themes as I was flipping through one of your pieces, and I’ll kind of give you carte blanche to talk about any of these, but you have a number of ideas from security and defence to the genomic revolution to the Aussie debt crisis and Canadian housing bubble. Man, that’s a lot. Which of those particularly stand out do you guys think as being a big opportunity or something that you think is an interesting area for examination?
Kevin: Well, we think they’re all interesting in and of their own rights. A lot of the Canadian housing bubble and Australian debt crisis themes are really housing bubble and high consumer indebtedness to GDP and housing type bubbles that are related to China and the Chinese capital outflows that have been pouring into those for so many years, propping up those housing bubbles and enforcing the citizens of those countries to have to go into extraordinary debt in and of themselves to chase these housing bubbles. And so it’s somewhat related to our China theme, but they’re housing bubbles in their own right and pretty interesting themes on the short side of the portfolio.
We are tactically net short, and so looking for short themes. But we’re not permanent bears by any means. We fully intend to get aggressively net long when our macro model is telling us we’re in the depths of a recession and stocks are cheap again. That said, we do have themes on the long side, too, above and beyond precious metals and precious metals mining stocks. And those would be our cybersecurity theme.
Really, it used to be a security and defence stock theme. The defence stock portion, they just got too expensive and frothy for our taste. So it’s really more of a cybersecurity theme now, where we like companies like Palo Alto Networks and Ford and then Check Point and CyberArk that score really well in our fundamental equity model and have still great growth characteristics going for them today. Even in recession, I think cybersecurity is gonna be an important spend area for people and for corporations.
Genomic revolution, really, that’s the theme that we’re excited to be long-term investors in. I think it’s the next great secular macro theme given the advancements in gene therapy and gene editing, and that’s just a place that we wanna be. Tavi, you got anything to add on that?
Tavi: If I would add, it would be more on the China-related themes, which is, you know, there’s another one that we have, the Asian contagion, which allows us to be short on some of the emerging markets, which are linked to China. But Canada, for instance, and Australia or really derivatives of the Chinese theme, and what’s interesting about Canada is we put out the stats a few, maybe, I don’t know, three months ago. It was very interesting looking at Canadian known financial stocks and realise that 82%, I believe, of those Canadian companies were losing money on the free cash flow basis. And at the same time, their unemployment rate is near record lows. And in it, you know, you start thinking about the distortions in the housing market in places like Canada, Australia, too.
But Canada, I think the IMF came out with the report, they call, I think, the Housing Watch. And they put out a ton of numbers that are kind of interesting. You can model them out and see and kind of create a model with all the metrics that they provide, and a few of them being price-to-income ratio and price-to-rent or just credit growth in general. And when you combine all those factors together, you see how Canada is just in another dimension.
And China is not even part of that research. For some reason, China and, I think, Hong Kong are not part of the countries that they cover by the IMF on that research on housing. But that just goes to show how incredibly overvalue is the whole entire housing market in places like Canada and Australia. It’s being kind of exacerbated by all the capital outflows from China, perhaps from the elites, and so forth, and the higher class economically from China trying to get their money out and investing in places like real estate in Canada.
And so we think that, essentially, the banks in those places are kind of holding the bag and they are the ones that are likely to suffer. And looking at the valuations of those banks, they look a lot like, you know, at the U.S. here, the American banks back in the peak of the housing bubble, some of those banks, especially in Canada, already kind of peaked in 2018, some at the beginning of the year, others at the end of the year, but they still look very, I guess, historically, overvalue. And so we find a lot of opportunity on the short side in those two places especially.
Meb: How are you guys expressing these trades most of the time? Is it going after indexes, individual names? Is it through futures, through options, derivatives? What’s the main way to think about a lot of these thematics?
Kevin: All of the above really. We have an equity model where we score individual stocks. We score 2,000 of the most liquid global equities, the trade on a U.S. exchange, and then we’ll go into a foreign market and apply our model to stocks in those markets, too. But our model, on a daily basis, automatically scores these top 2000 U.S. listed stocks. And so we trade individual stocks, long and short. We will trade ETFs when it makes sense.
Our twilight and utilities theme, for instance, is an interesting one to talk about, because, actually, utility stocks are the worst scoring sector in our fundamental equity model today. On a valuation basis, they’re the most overvalued relative to their own fundamental metrics in history. They have the most debt that they’ve ever had in history. And on an aggregate basis, the entire sector generates negative free cash flow and has for the last several years.
It’s really amazing that the world perceives utility stocks to be a defensive sector that people wanna chase when it’s late in the business cycle. And we found that utility stocks actually, they’re low beta is attributable to the fact that they go up less than the market in rising markets, but we found that the beta is about 0.95 in bear markets. And so they get clobbered along with the rest of the market in bear markets, and they’re the most overvalued that they’ve ever been. So that’s a trade that we’ll express through…actually, because they all scored terrible, we’ll use an ETF. And because the volatility is so low, we have put options on the XLU ETF, for instance, because we think that’s just, you know, a terrible mismatch and an incredible opportunity at what we think is to short something at the peak of a cycle.
Meb: This is an idea that I haven’t heard that much about in the general media and social threads. I wonder if it’s just something that people think or are just complacent about utility stocks and just picture them as always being safe. I remember reading an old Shiller paper that looked at sector P/E’s CAPE ratios on various sectors. I think he had, at one point, utilities hitting like a 50 or 60 CAPE ratio on the roaring ’20s. It just goes to show you can have a bubble at just about anything in boring utilities. But I wonder why no one is really talking about this. Is it something you guys have any opinion on?
Kevin: Not only is no one talking about it. Hedge funds and other investors are record overweight utility stocks right now, and, of course, they’re hitting all-time high. But in the 1929 crash, and, you know, through 1929 to the bottom of the market in 1932, utilities were down 95%. Shiller CAPE ratios were absolutely right. And they were down just as much as the market, 92% or whatever it was, during that crash.
Tavi: The utilities is even more interesting when you overlay with the macro research and looking at… We put out this research on what we call the battle of safe havens and looking at the relationship between U.S. Treasuries, 10-year Treasuries, vs. Utilities stocks. And what you found is that, you know, every time they start to diverge from each other, in other words, Treasuries begin to rise as utilities begin to fall, it tends to be, you know, that tends to happen at the end of the business cycle.
So one way to look at that to measure the relationship is, again, look at the 52-week rolling correlation of the two indices. And what you find is that, in 2007, kind of mid-2007, that correlation turned negative for the first time right at the peak of the market. And right now, more recently, we just had our first print of a negative 52-week correlation between the two. So it’s kind of interesting when you looked at that way as well.
Meb: That’s fascinating. I’ll definitely look some more into that. I think that’s a really interesting area. So as people listen to this podcast, whether it’s professional investors, individuals, across the board, obviously, the first answer is they call you guys up, email you, allocate to your fund. But for people who believe in your worldviews or some of these ideas, what do you think are kind of the main muscle movements or levers that would be a good takeaway from this portfolio? Is it most people should think about perhaps reducing their equity allocations? Should they think about more from the standpoint of hedging and buying puts? Should it be reducing exposure to China? What do you think are kind of the main takeaways for someone who has a traditional buy-and-hold, global 60/40 sort of allocation?
Kevin: Sure. I think that people really need to think about doing some more tactical asset allocation, not just being a buy-and-hold forever investor. There are important times when you need to look at the valuation and where you are in a business cycle. I mean, you look at the market cap to GDP right now for the overall U.S. market, and it’s the highest it’s ever been at, you know, 140% market cap to GDP, you know, above where it was in the tech bubble in 2000.
And there’s been so much focus on buy-and-hold and long-term investing in equities and ETFs. And it’s great. I mean, they have a great place in investors’ portfolio. I just think people should think about becoming increasingly defensive today, look at some alternative asset classes, you know, of course, like our funds, but things like gold, which have been left for dead now for the past five to seven years.
And one thing that we look at is the S&P to silver ratio, for instance. And it’s at the highest ratio that it’s been since the tech bubble. Silver, of course, is like gold on steroids when gold gets into a bull market. There’s some really cheap commodity asset classes out there. And in what we call the everything bubble that we think has largely been driven by the Fed and global central bank’s interest rate and Cubic policies over, you know, since the global financial crisis, it really has not contributed to rampant economic growth. It’s contributed to asset bubbles across global equities, across credit, across real estate, you know, around the globe.
And if you participated in that, if you’ve been fortunate enough to be among, you know, those who have savings that have been put to work in the markets, you know, you’ve done great. And it’s just time to think about, you know, taking some off the table and positioning a little bit for a tactical, you know, for a business cycle correction. And, I mean, the risks today are enormous, you know. They’re just getting back to mean valuation multiples, where you’re looking at a 40% kind of correction in equities.
And when you get into business cycle downturns, market doesn’t tend to stop at the mean. Is it going to be as bad as the tech bust or the global financial crisis? I don’t know. I don’t know what kind of rabbits the central banks are going to pull out of their hat this time around. But if they really do go for the massive QE button early this time around, boy, precious metals sure should have a place in someone’s portfolio, I think, in this cycle. Tavi, you got anything to add on that?
Tavi: Yeah, I think it all depends to the, you know, kind of the level of sophistication of the investor. But at some point, you know, having cash, precious metals, and perhaps some Treasuries, I’ll elaborate a little bit on this, but if you have let’s say, you know… One ratio that we really think that is poised to rise much further is gold to S&P 500 ratio. I don’t think it’s too hard to position yourself in that direction.
Another way to do it is, like Kevin said, I think you put a chart on Russell 3000 versus silver, it’s near all-time highs and just kind of formed this double top, and it looks really interesting as technical fundamental and macro trade as well.
Now in going even further on the Treasuries part, we think that one trade that is kind of interesting, unfortunately, it got to be a little bit more sophisticated to do that, it would be getting long U.S. Treasuries and short German bonds as we think that those rates will likely converge or at least narrow the spread. You look at historically those spreads, they tend to narrow as the crisis unfolds, and usually because of some sort of safe haven kind of flow towards Treasuries that is higher than towards German bonds perhaps because of the dollar being a more stable currency and so many possible answers to why that spread narrows every time a recession or a bear market starts to unfold.
But I think that those are maybe some interesting parts. And, I mean, obviously, our portfolio is going in an even higher way of, unfortunately, most people won’t be able to probably do this trade, which is being long gold in yuan terms, and that’s a little bit more difficult. But even at a higher level it would be long gold in yuan term versus global stocks, and that’s what we call the macro trader of the year. We’ll be happy to elaborate more on this.
But that’s essentially the way 80% of a portfolio is positioned today, is being long gold in Chinese currency terms. So as the Chinese currency devalues versus the dollar, that will increase the value of gold perhaps in local currency terms, and therefore, as global stocks also sell off, that ratio is likely to rise. And we have several charts kind of going back in history and showing that relationship when the market tumbles in places like the China, at least all the way back to the 1990s and quite interesting research.
Meb: It seems to be a good hedge to market frictions, but maybe we should launch this ETF. That’s a good idea. Cambria will put out the long gold in long-term short stocks. As you guys look around the world, we got to start to wind down here soon, this has been a lot of fun. But as you think about some of the fundamental inputs and indicators, we’ve talked about some kind of widely discussed ones, the CAPE ratio, obviously, we love yield curve, which I imagine is probably the most talked-about one in the media right now, are there any other kind of wonky ones you guys look at or ones that maybe you interpret differently or anything that you think is particularly useful that either other people aren’t aware of or they don’t talk about or they use incorrectly? Any fun ideas there?
Kevin: One that we really like to look at is consumer confidence. And a lot of people, you know, will look at the market today, and I think this is why the majority of the people really fail to see the top of a business cycle, is, normally, the top of business cycle, everything looks great, you know: low unemployment, high consumer confidence, stock price is doing well, people’s portfolio is looking good. And they say, “Well, how can a recession be around the corner?” But that’s the way that it works out almost every time. As unemployment reaches a record low, consumer confidence reaches a record high, stocks reach record highs, literally months or a few quarters before the next recession.
But consumer confidence is one that, right now, if you look at the two components of the consumer confidence index, consumer confidence expectations versus present situation, when you see a big divergence in the downward and the consumer confidence expectations versus the present situation, it’s been an uncanny timing signal for the top of the business cycle. And right now, we’re at a near-record divergence of the two almost as significant as it was in 2000 at the same time as the overall consumer confidence in index is near, you know, record highs, something like in the 96th percentile. That’s just one. I think Tavi has got another one here, too, if you’re interested.
Meb: Real quick before Tavi, the Leuthold and their recent Green Book, which listeners, if you can get ahold of, this is one of my favourite reads every month, actually had a great chart on that topic, and they divvied it up into when consumer confidence is high and low and then in which direction is it moving. And it’s a really interesting takeaway, where you can kind of put in various quadrants and see just when consumer confidence kind of turns and starts to really back off that things can get dark pretty quick. Anyway, I direct you guys to Leuthold, if you can find it. We’ll post it to the show notes if they let us. All right, Tavi.
Tavi: Well, the other thing that I think we’re looking at, I think there are a lot of other managers and funds have been kind of looking at this as well, but in a different way in terms of twin deficits in the U.S. with the current account and the government budget. That said, you know, if you add both, and the government budget, just by looking at the change and public data, like, I guess, people like Jeff Gundlach has been kind of doing. But a lot of people have been looking at that chart of twin deficits to GDP, which is close to 8% today of deficit. And linking it back to Treasuries and the dollar, you know, it’s all very interesting.
But, you know, if you link with stocks, especially the S&P 500, it actually tracks each other really close, and it’s just now recently kind of formed this alligator mouth between the two, which we think it’s kind of, you know, telling us a story very well of this bearish thesis on U.S. equities in general. So we like to look at this twin deficits, you know. I think there’s a much better link with equities than other asset classes.
Kevin: The idea of using the twin deficit argument to short bonds, to short Treasury bonds, it is an interesting one. It’s just that we have so many other indicators lining up today that show that buying Treasury bonds might actually be a good play today when we look at this twin deficits versus the stocks, it just screams out at you that short stocks looks like a much better way to play it.
Meb: You know, what’s funny is I laugh, because the U.S., as we look around globally, it’s still crazy. You look around in parts of the world where the sovereigns, even on now to 10 years, are below 100 basis points, in many cases, negative, which is probably the biggest surprise of my career. I mentioned on this podcast the fact that we see negative-yielding sovereigns. I don’t think it’s something that I ever expected to see in my lifetime. But the fact that the U.S. is now a high-yield market, it’s like, if you look at the high-yield bucket, it’s a bunch of emerging markets in Brazil and Mexico and the United States.
Kevin: I think the 10-year yield in Greece went below the 10-year Treasury yield here in the U.S.
Meb: Well, crazy times we live in, man. But, hey, that’s what makes markets fun, you know. And it’s never a dull day. You know, it’s funny, as I talk about valuations, and I agree with you guys on U.S. stocks. We tend to have different views on foreign equities. But one of the things that any good analyst or PM spends time doing is trying to look for kind of, you know, opposite evidence, you know, on the valuation side. I say, “Look, I can’t find a valuation indicator that says that U.S. stocks are cheap.” We always tell readers, “Send one in if you find one,” and nobody has one.
Is there anything in your mind that’s actually showing kind of opposite signals to your thesis, where you look at and say, “That’s an interesting indicator,” or maybe “that’s an interesting sign,” or maybe it’s just showing that it hasn’t really turned yet? Is there anything that’s sort of in your models that are saying, well, this is bad, but it’s not awful yet in regards to kind of y’all’s thesis? Or that you say, “This is a concern in my head, too, are the opposite side of our trade that we think about?” Anything in that general line of thought?
Kevin: When you dissect S&P 500, balance sheet, income statement, cash flow statements today, some of the things that really stand out beyond the valuation multiples that we already talked about are the fact that we’re at record profit margins, we’re at record free cash flow margins, and we’re at record debt in terms of corporate debt. And so there are some things that still, you know, look okay, obviously, in terms of profit margins have been expanding and free cash flow margins have been expanding.
But when you look at it, and you look at the tax cut that we had last year, I mean, it’s understandable that you would get a big goose in these margins. And doing that so late in the business cycle, now here we are going into Q1, and the reporting season just started. Now I realise there might be some positive surprises, there usually are, to analyst earnings estimates. But let’s just say the analyst earnings estimates come in on track this quarter, and it’s gonna be a negative year-over-year earnings growth. And so we think there’s this huge deceleration of growth and momentum that we had after last year, fundamentally creating the largest profit margins that we’ve ever had, the largest free cash flow margins, the most debt. It’s just setting up to be something potentially spectacular when it finally does unwind.
Meb: I hear you. All right, gentlemen, as we wind down, our question that we’ve been asking everyone, and you guys both could answer this, and this can be personal, it could be fun, it could be good, it can be bad, what’s been your most memorable investment that you can think of? And I’ll let you guys pick who goes first.
Kevin: One that I’m most proud of recently really is an idea that came from our equity model back in 2014. I presented it at a value investing conference here in Denver, in Vail, actually back in June of 2014.
Meb: Is this the VALUEx?
Kevin: It was VALUEx, yeah. We presented it in video, which was scoring at the top of our model. We owned it. And I think it was close to 20 bucks a share. We held on to it for three… After that, it was the number one performing stock in the S&P 500 for 3 years straight. Yeah, of course, we got out of it too soon, but we had, like, a five bagger, and what’s wrong with that. So that’s one that I’m most proud of.
Tavi: I’m relatively young, I guess, but I do have one that was very memorable for me. I tend to like macro more, I guess. We started really talking about China back in 2013, I think, 2013, ’14. Right before the mini-deval in August of 2015, which, I remember exactly we start kind of putting together all the whole thesis and why we thought that the Chinese currency was overvalue. And I remember kind of putting the whole presentation together, and not a single person was talking about this.
And we called the brokers. And trying to put that trait together was very challenging at the time, but ended up working out. And then I remember exactly when it all happened in August. It was a big surprise, even for us. I mean, we didn’t think the options are gonna move that much, but it ended up being obviously memorable, because it was a great one. I have other bad ones, too, but that one was memorable, I guess, because of the size of the trade and overall. But obviously, we still kind of continue to have the same view with such a small move compared to what we think is likely to happen in the future. I guess that’s the one that sticks in my head the most.
Meb: I like it. You know, it’s funny you look back on the sentiment regarding China. I mean, the younger listeners on this podcast aren’t gonna remember this, but the mid-2000s, when everyone wanted the BRICS, I mean, India as well and China, we’ve got into CAPE ratios in the ’40s and ’60s, and every institutional dollar was just… Every conference you went to, everyone was BRICS, BRICS, BRICS. And, you know, those markets have struggled so much since. And it’s crazy to think back at about how strong the sentiment was then and, you know, how it plays out.
Gentlemen, any final thoughts before we wind down and let you get to your weekend?
Kevin: We really thank you for this opportunity to be on your podcast. It’s great talking with you. I think this China theme is still perhaps our biggest theme that we have overall in the portfolio. We don’t think anything has played out yet in terms of the potential yuan devaluation. And when China was opening up and moving more in a market-oriented direction, absolutely, it was a great growth story. I think too many people are looking back to a different time, and China is really going the other way in terms of being a much more authoritarian communist country, centrally-planned, you know, the lack of freedoms and… I mean, how can you have a market-driven global trade economy with a closed capital account. It’s just absurd.
And so if there is any risk of what might be the trigger, we think it is something with the going, you know, not to full expectations with the China trade deal. And a lot of the economic signals that we’re getting for downturn in the global economy today, you know, really are coming from China, coming from Europe, just a number of economic indicator divergences that point to a slowdown, at least in the global economy. And anything goes wrong in the world, we just think it has a likelihood of coming out of China.
Meb: We didn’t get to talk about it today, but it’ll be interesting to see how much of an influence the increase of the Chinese equities in the various market cap weighted indexes. But that’s been a topic on the other side, as to potential, the bullish case where people talk about flows as they increase their tradable percentage, at least here in the U.S. where some of these institutions will be forced to buy some of the securities in the coming years. I don’t know if you guys have any thoughts on that.
Kevin: Yeah, well, that is a counterforce, no doubt. I don’t even know how China was allowed into the WTO in the first place, let alone into the MSCI Emerging Market Indices with so many of the non-market-oriented practices that they employ, but such it is.
Meb: Well, gentlemen, this has been a lot of fun. Where do people go to find more on y’all’s research, ideas, fund offerings, thoughts, all that good stuff? What’s the best place find y’all?
Kevin: Our website is crescat.net, C-R-E-S-C-A-T. We’ve got a lot of information up there. You can send an email to firstname.lastname@example.org. Tavi and I are both very active on Twitter and social media, LinkedIn, and YouTube. We’ve started posting little brief macro presos on YouTube. So go check that out. You can find most everything just up on our website.
Meb: Awesome. Gentlemen, thanks so much for joining us today.
Tavi: All right. Thank you.
Meb: Listeners, we’ll post the show notes, the links, the emails, all the good charts stuff we talked about today at mebfaber.com/podcast. You can find all the archives on there, over 150 shows. We’d love to hear your feedback. Shoot us an email, email@example.com. Please leave us a review, you love it, you hate it, anything in-between, and subscribe to the show on iTunes, any other place that…any of the apps you like the most, Breaker, Stitcher, RadioPublic. Thanks for listening, friends, and good investing.