«Central banks basically are penalizing savers and pushing people into riskier and riskier assets. But they can’t repeal the law of economics.»
It’s getting ugly. Around the world, equity markets are in turmoil. At start of this week, the S&P 500 dropped to the lowest level in more than a year and many investors are becoming anxious. With Kevin Duffy the opposite is the case. The co-founder and Principal at Bearing Asset Management is an internationally renowned short seller. With his investment style he is one of the increasingly rare financial specialists who are betting against stocks and other securities they think will decline in price. “Since the beginning of October, it’s been the ideal environment for us”, he says in an extended interview. He is convinced that the equity markets are the beginning of a prolonged, grinding downturn and unveils which stocks will suffer the most in the coming year.
Mr. Duffy, the financial markets are in turmoil. What is facing investors in the coming year?
My easiest prediction would be that the equity bubble and the everything bubble starts to unwind. This year was a transition year. We certainly saw a bear market in most of the world’s equity markets. So far, the US has been able to avoid that. But next year is going to be a risk-off year. We will have a lot of declines in asset prices whether it will be in real estate or in stocks. So, the next act is that we are officially in a bear market in US stocks and I don’t believe that this is going to be a short and sweet downturn like most people think. I really believe we’re going into something very different: a prolonged, grinding affair that turns off a generation of investors from equities.
That sounds fairly dark. Why do you expect a crash?
One of the reasons is complacency. Central banks have artificially lowered interest rates for such a long period of time. That sets things in motion. It changes behavior. After a while, people get conditioned to ignore the early warning signs. Today, after ten-and-a-half years of rising asset prices, ultra-low yields and debt buildups without serious credit consequences, extrapolation seems to be the order of the day. Most investors think that stocks will continue to rise, the Federal Reserve will prevent a severe bear market, and every dip is a buying opportunity. After so many false alarms, they have been conditioned to rush into the building at the first sign of smoke. So, sentiment wise I think we’re set up.
Then again, this so called buy the dip strategy has paid off very well over many years. What makes you think this time it will be different?
I keep an eye out for red flags. One red flag is deteriorating market leadership. This criterion was satisfied in September as the S&P 500 exceeded its January peak while the median stock stalled. The 13% correction in the S&P 500 since its September 20 closing high has been broad-based, even dragging down the formerly-Teflon FAANG stocks, which shed more than 20%, or more than $700 billion, of their combined market cap. Worse, most large cap tech darlings issued weak fourth-quarter revenue guidance and appear to be running out of growth runway.
In addition to that, there are growing tensions in the credit sector. What’s your take on that?
To me that’s another big difference right now. I think it’s different this time because we’re now in the part of the credit cycle where rates are going up and credit is tightening. There is maybe a bit of a misunderstanding out there, that this is a result of the central bankers wanting to do this by tightening monetary policy. But they are behind the curve. They are just reacting.
What do you mean by that?
We’ve already talked about investor conditioning and complacency. But artificially low interest rates also condition economic actors to reduce their savings. Central banks basically are penalizing savers and pushing people into riskier and riskier assets. But they can’t repeal the law of economics. As the pool of savings is diminished it actually drives up interest rates. It’s like pushing a beach ball under the water: forces are building up to pushing it back up. That’s where we are in the cycle today. This is one of the big changes going forward.
What are the implications for investors?
There are two serious problems: debt and demographics. At the top of the technology bubble in 2000, the world had about $70 trillion in total debt. At the top of the credit bubble in 2007, it was about $150 trillion. Today, on the top of the everything bubble, it’s $250 trillion! Of course, there are huge differences in terms of these three bubbles. During the credit bubble, a lot of new debt flowed into mortgages. It was consumer debt. This time, it has been governments which have taken on large amounts of debt. This creates moral hazard, a false sense of security that governments have infinitely deep pockets and that deficits no longer matter. But deficits do matter as I recall. In the nineties for instance, there was a lot of concern about debt and the deficit in the United States.
And what about demographics?
We also have a demographic problem in the United States, especially in terms of the Baby Boomers. They have always consumed too much and did not set aside enough. They have been run over by the technology bubble and by the housing bubble. So, what should they have done? They should have become more conservative and saved a lot more. Instead, the Fed comes along and discourages saving. Therefore, the Baby Boomers doubled down and tripled down. They took on a tremendous amount of risk; not just with their own investments but in their pension funds. They bet all their money on these asset bubbles. But what happens when these bubbles reverse? The Baby Boomers are going to be in trouble and will be living off their Social Security benefits. This will be an enormous strain on public finances, especially if interest rates go up. For example, if rates were to tick up to just 5% until 2028, net interest would consume 20% of the federal government’s budget.
How does an experienced short seller like you prepare for these kinds of troubles?
For decades, bond investors have been incredibly hospitable. But it’s expecting an awful lot for that to continue. We had a 35-year bear market in bonds, followed by a 35-year bull market. But now, we’re 28 months into a new bear market. You are starting to see some cracks. You are starting to see rates go up in Italy and you are starting to see rates go up in high yield bonds. And, you’re seeing price inflation everywhere which is one of the things tying the hands of the central bankers. That’s why one of our short positions are German, Italian and Japanese government bonds.
Short sellers had a hard time in this historic bull market. How do you experience the current market environment?
Since the beginning of October, it’s been the ideal environment for us. As a short seller, I feel like a mosquito in a nudist colony right now. But for a long time, there has been an all-out war on short sellers. Not directly, but indirectly by the policies of the last ten years in terms of suppressing interest rates. It ignited this asset bubble. If you go back to the previous bubble, the housing and credit bubble, that period of artificially low rates lasted about two and a half years. This time, it lasted over seven years. So, it’s really been unprecedented. It’s been very difficult as a short seller to survive in this kind of environment. As a result, there are so few of us remaining. To give you an idea of just how decimated short biased funds are, look at the assets of inverse ETFs in comparison to total ETF assets. Today, these assets are less than 0.4% of total assets.
So how does your investment strategy look now?
As short sellers, we’re looking for opportunities that typically show up at the intersection of secular headwinds, debt buildups, asset bubbles and flawed business models. In other words: we’re looking for the grass huts which are most vulnerable in the coming economic storm. That’s really what we are focused on: businesses which depend on cheap credit, are exposed to consumer fads, are capital-intensive, cyclical with low barriers to entry, competition knocking on the door and too much leverage.
Where do you find such companies?
One of the headwinds that we see is that the consumer is really stretched. There is too much debt and there are not enough credit worthy consumers to loan money to. A good example is the auto loan market. If you look at a company like CarMax, their past due accounts have been slowly going up during this cycle. So, what we’re looking for is cracks that are already starting to form even though you’ve had a boom covering things up. That’s the case with nearly any extending consumer credit business. Cruise lines, for instance, are another interesting area. Basically, anything that’s a big-ticket item in terms of discretionary spending and will suffer when consumption goes down.
Where else do you spot short opportunities?
At Bearing, we have probably fifteen different investment themes which we are short in our funds. China is in that group, especially Chinese financials. Another one is the Canadian housing bubble. There, we are using put options to short big institutions like Canadian Imperial Bank of Commerce which has high borrowing costs and a lot of leverage. Then, there is the passive investing bubble. Over the last nine years, we’ve had $2.5 trillion flowing into passive equity funds and we’ve had $2 trillion flowing out of active funds. What happens if this trend reverses?
Which companies could get into trouble?
Here’s the problem with the ETF business: People think that it’s a great business and that it will just continue to grab market share. Therefore, investors think ETF providers like BlackRock and State Street will continue to do really well. But this business is just cutthroat competitive and it’s a race to the bottom in fees. So, you have these high fee incumbents like BlackRock and then you have lower fee aggressors like Vanguard which basically is a non-profit. We’re also shorting the index providers, another interesting niche in the passive investing area. MSCI is the big one there. This is a company which is subject to the same fee compression. They are competing with firms like Morningstar which are willing to provide their indexes basically for free as a loss leader to build their brand. Additionally, they’re competing with self-indexing: Customers like Vanguard or Charles Schwab can basically create their own indexes to cut out a firm like MSCI.
Are there also stocks you wouldn’t short or even hold long positions?
We don’t like secular tailwinds. That’s why we try to avoid technology and health care. There are just too many better opportunities out there. We’re facing an aging demographic and there are going to be consumers who are stretched. Who is going to help to solve these problems? Discount retailers like Walmart and Target. We don’t want to short such companies. In fact, we like discount retailers. We don’t have any investments right now. But they are on our radar on the long side. In Switzerland, Roche Holding would be an investment which would be on the long side, as well. We’ve owned the stock in the past, but we don’t own it right now.