Given the brutal start to the markets in the first three weeks of 2016, we thought it a good time to check in with the team at New Harbor Financial. We have had them on our podcast periodically over the past years as the market churned to ever new highs, and have always appreciated their skepticism of these liquidity-driven ""markets"" as well as their unwavering commitment to risk management should the party in stocks end suddenly.
So, how is their risk-managed approach faring now that the S&P 500 has suddenly dropped 8% since Christmas? Quite well. Their general portfolio is flat for the year so far — evidence that caution, prudence and hedging can indeed preserve capital during market downdrafts.
We've invited the New Harbor team back on this week to hear their latest assessment on the markets, as well as how they're approaching their portfolio positioning moving forward:
We spend a lot of time talking about position sizing. Right now we have very little in the stock market. We never cheer for a crash in the sense that we know a lot of people would likely get harmed in such a scenario, but we also spend our time assessing reality and probability. The likelihood of probability for a crash certainly has never been non-zero, but it has developed a greater likelihood than it had even just a few weeks ago. There has been a notable sentiment change.
I'd like to point out: we're not even a month into the year and we have already clawed back over two years’ worth of gains in the stock market. Even if you look at the S&P 500, which has been the most lofty because of its capitalization-weighted nature, where we are at right now takes us all the way back near the end of 2013.
There is a set of conditions — deterioration of breadth, deterioration of market internals, a sudden shift of investor mindset from speculation to conserving capital — when these kinds of things are present, at least history says it almost does not matter what the central banks do. In fact, when they get more and more aggressive in those kinds of environments it may just convey greater desperation and panic on their part. Investors run to the sidelines even more quickly. It would take a lot right now in changing those things for us to want to put down our defenses in any material way due to central bank desperation at this point.
This is a time for holding things like cash, holding things like very short-term high-quality treasury bonds, having some hedges on. Even in a crash scenario at some point this kind of strategy could actually have positive, albeit modest, additive value to an account. Sometimes the simplest thing you can do is the best way to avoid getting harmed in the crash: that's holding cash and just staying out of harm’s way. It happens to be one of the hardest psychological things to do, but it is one of the most effective ways.
Transparency note: As a result of our public endorsement, Peak Prosperity has a commercial relationship with New Harbor. The details of this relationship are clearly presented in writing during the referral process — but the punchline is, our relationship does NOT result in any increased fees to those who become clients.
If after listening to this podcast, you find yourself interested in connecting with Mike, John, and the rest of their team to learn more about their advisory services, please use the form here to do so.
It should go without saying: this discussion should NOT be construed as individual financial advice by those listening to it. The content should be taken as informational and educational in nature only. Investment advice must be tailored to your specific personal situation (which we and our guests are obviously unaware of) and should be obtained directly from a financial adviser you trust. Before acting on any of the statements made in this podcast, we advise you do just that.
Click the play button below to listen to Chris' interview with New Harbor Financial (32m:28s)
Chris Martenson: Welcome to this Peak Prosperity podcast. I am your host Chris Martenson. Today we are going to discuss the recent market volatility and how to protect your portfolio during such periods. Unless you have been under a rock, the opening weeks of 2016 have been terrible for equities and oil, and are now among the worst starts to the year—if not the worst start—in history, depending on the market we are talking about. You probably also know my position, which I have held for years. All this money printing and debt accumulation was going to end in tears. A year ago on this show, Adam Taggart discussed the ins and outs of hedging and risk management with Mike Preston and John Llodra, the lead partners at New Harbor Financial. Today we are going to build on that and talk about how the team at New Harbor is managing the recent volatility, and how their ideas of risk management are working in practice.
New Harbor is the financial advisory firm officially endorsed by Peak Prosperity. For full disclosure, we have a business relationship with them, which we always disclose when we have them on the podcast. You will also find it within the write-up that is going to accompany this discussion. With that out of the way, let us dive right in. Welcome Mike.
Mike Preston: Thanks Chris.
Chris Martenson: Welcome John.
John Llodra: Thanks Chris, hello. Hello to our listeners.
Chris Martenson: Great. John, I want to start right at the top. Let us just dive right in. Since the beginning of the year S&P is down about 8.5%. How has your average portfolio performed?
John Llodra: I guess I can put it that we are roughly flat on the year. We are not posting big gains. We are not celebrating huge gains from being short the market. But we are roughly flat for almost every one of our clients, so we are very happy to be largely, if not entirely, immune from the volatility we have seen so far this year.
Chris Martenson: For the average person out there who has just sort of held on and has followed the lead articles in all the major newspapers, they are down 8.5%. They have to make that back up. You guys are flat.
John Llodra: That is about right. You know, to be fair our career and our experience with clients do not start at the beginning of the year. You have to be early sometimes to be right. Certainly we have been positioned in respect of, or in anticipation of the kind of thing we are seeing right now for some time. We did not wake up on January 1 and decide to get positioned in the way that we are positioned right now to allow us to avoid much of the decline that has happened this year.
Chris Martenson: I know. It is very hard to be disciplined, especially in the last end of a rising bubble market. It is really hard, so kudos to you gentlemen for that.
Mike, again, quick recap for everybody on the sorts of strategies that you use again. What are the basic tools and approaches that you talked about before just so everybody is on the same page with what we mean when we say "risk management"?
Mike Preston: Sure Chris— this is Mike Preston of course. We are tactical investment managers. We are making decisions about broad market risk. We are taking more risk at certain times and less risk at other times. What has been really unique about these last few years is that we became more and more conservative starting sometime in late ’12 and early ’13. In all fairness just like John said, we were early in getting mostly – not completely – out of the market, but getting mostly out of the market. We certainly are early and that stung a little bit. Our clients can attest to that. There is really no way to get out at exactly the top. The tools that we use to apply the risk management structure style that I just described are investments that most of your listeners will be very familiar with. This is such as stocks, bonds, exchange traded funds, options, and even a mutual fund here or there. A big thing that we do use electively that most money managers on Wall Street do not use is cash. We are not afraid to hold a lot of cash, and that has not been very comfortable either the last couple of years, particularly with interest rates at zero. We have held a good amount of cash and an increasing amount of cash over the last couple of years. Frankly, that is what has helped us weather this most recent downturn.
Chris Martenson: Holding that cash position, I assume that at some point you are holding that with the idea of bringing that dry powder out of reserve and beginning to redeploy that. When does that start? Has it started? When will you know the time is right? What are you looking for? John?
John Llodra: We deal in an imperfect science to be sure. There are some very time-tested and statistically robust ways to be in the right neighborhood. We are not about precision. We are about being in the right neighborhood. As distant a memory as the ’08-’09 crisis might be, maybe it is a more recent memory for those that have seen the great movie, The Big Short. You did not have to be exactly out at the top and exactly in at the bottom of that episode to do remarkably better than just a passive "close your eyes" kind of approach. Certainly we have our viewpoints on where fair market value is for the various markets we look at—things like price to equity ratios, price to sales, and price to book—these fundamental measures that a prudent logical investor would be willing to pay for whatever they are looking at. Let us call it the stock market or a given stock. In reality, markets behave through animal spirits on the short term. That is a reality of the world we live in. So we look at other things like technical indicators. I am using kind of a buzzword there to encapsulate a whole bunch of other things.
Maybe look to yesterday as an example. Here we are the day after a pretty big swoosh down to take out the August 2015 lows. We are now back above those lows, but yesterday was the swoosh that took those lows out. There were some pretty good technical bases for a bounce in the area of 1820 on the S&P 500. Within just a few points is exactly what happened yesterday. Did we think that 1820 is the bottom of the market? Absolutely not. There are very good fundamental reasons why the selloff in this market can go much further than we have gone thus far. We would not... First of all, a 20% pull back from the all-time highs is almost—I cannot say a certainty—but a very high likelihood we are a little over halfway there right now, so there is still plenty to go on that basis.
On just almost a slam dunk kind of average fundamental evaluation basis if you look over a long period of time, getting down to 1400 or even a little bit below there on the S&P is not at all out of the realm of history in terms of what one might expect. That is quite a bit further down from here. Here we are down at high 1800s on the S&P, so it is quite a bit further down there. Rarely do things like that happen in a straight line. That is where we try to bring our shorter term technical tools to bare to hopefully do some tactical "in and out", if you will, of various asset classes to capture some of those breather points. As we said, like 1820 yesterday in the S&P was a support level. We did some trades for some accounts that actually had the effect of getting modestly invested in stocks yesterday on that pull back. It had the ability to hedge on the downside too using some of the tools like Mike talked about with options.
It really is not a flick of the switch thing. You might gather from reading some of the headlines that you have to be either all in or all out. It is not that at all. We spend a lot of our time discussing with our investment committee, Mike and me and our other partner Bill Cole, position sizes. What is the relevant amount to have exposed in a given market or sector given where we are right now? Right now it has to be very low stock weighting, which is quite contrary to where we were in 2008 and 2009 when we had very large stock weighting after the big sell off. Hopefully that was not too long-winded, but we use a pretty robust set of tools to help guide us in deploying decisions like that.
Chris Martenson: Obviously within a lot of the day-to-day movements you are keeping your eye on the ball. It is a very active management style. I am wondering about too sort of the macro perspective. If you read broadly, which I know you gentlemen do because we talk about it – when you read broadly though and you find out what is happening in China, what is happening in Europe, and what is happening in the emerging markets. It feels like this is a very inter-connected investment environment compared to even just 10 or 20 years ago. How much are you sort of factoring in that larger picture with sort of data points as you being to assemble what you are thinking of doing?
Mike Preston: Chris, I will respond to that. This is Mike. We are looking at macro issues or fundamental issues, if you will, when we are making our decisions as well as looking at technical issues. Let me give you a few ideas of some of the themes we might be looking at fundamentally. For instance in the commodity sector, the commodity sector has been hit really hard the last couple of years. It is pretty clear to us and I think a lot of people out there, including you Chris based on some of your writings that deflation seems to be winning here. It seems to have the upper hand over inflation short-term. Central bankers want inflation. Deflation seems to be what the problem is, so that is crushing commodities. There may be some opportunities in some certain commodity markets, like the energy markets, to try to bottom fish some of those things—either the commodities itself or some of the companies that produce those commodities. We have the tools to engage in certain trades that we can have at least a little bit of a hedge. We can enter some of those markets without having to pick the exact bottom. We are talking about some ideas like that as we speak.
Other things from a macro perspective that make sense—we think some core holding in gold makes sense for a lot of people. Gold has been miserable the last three or four years unfortunately. Sentiment is probably about as in the basement as you can imagine. Gold is pretty hated. Frankly there is some concern—per my previous comments about deflation—there is some concern that gold could continue to be pulled downward by the weight of other commodities and their bear market. However, it is the only thing that we think could potentially have a positive response to what we see as recklessness of the central bankers and maybe even a flight to safety type reaction if things get a little crazier here. Gold is certainly part of what we do and what we think about. We try to be tactical about it. But at some level there are some small positions that we hold on a longer-term basis.
We talked a little bit about energy being down. We look at spread type trades that we can do to attempt to pocket the difference for our investors between two different asset classes. For instance, right now we have, still, a trade on where we are long the S&P 100 and short the Russell 2000. We think, frankly, both markets will fall. We just think the small caps will fall faster, and that has happened so far. We might look to take a profit on that sometime soon.
Other examples might be buying emerging markets and shorting domestic markets like the S&P. These are other things that we are talking about now. From a macro fundamentalist big picture point of view, those are some examples of what we are talking about for trade ideas. Some of them might actually make it into our portfolios. That will hopefully give your listeners an idea of how we work.
Chris Martenson: Yeah, that is fantastic. Of course you have to keep your eye on not just the ball but lots of different balls. As I track things right now, obviously there is a lot of uncertainty across the whole world landscape. It feels a little like 2008 to me again. History rhymes, never exactly repeats, but the rhyming portion of this with the whole emerging market situation right now speaks to a flood of liquidity that is now draining from those areas where before it was going in. That loss of liquidity was a hallmark in 2008. It just struck a different sector than emerging markets at that point. I guess that leaves open the idea that one of the number one concerns that I think a lot of average investors have is this idea of a big crash—something that would really come along and fundamentally change the landscape pretty quickly. How do you anticipate your model portfolio would work during the time of a big crash?
John Llodra: I will take a shot at that Chris. This is John again. We spend a lot of time talking about position sizing. Right now we have very little in the stock market. We never cheer for a crash in the sense that we know a lot of people would likely get harmed for such a scenario, but we also spend our time assessing reality and probabilities. The likelihood or probability of a crash certainly has never been non-zero, but it has gotten very much a greater likelihood than even just a few weeks ago. There has been a notable sentiment change. Holding things like cash, holding things like very short-term high-quality Treasury bonds, having some hedges that actually—like Mike talked about are the spread trade that we have on; even in a crash scenario something like that could actually have positive, albeit modest, but positive additive value to an account.
Sometimes the simplest thing you can do is the best way to avoid getting harmed in the crash. That is holding cash and just staying out of harm’s way. That is one of the best ways. It happens to be one of the hardest psychological things to do, but it is one of the very most effective ways. We feel very confident that if a sudden sharp crash type of decline were to happen, our clients would certainly on a relative basis do quite well. We set our bar pretty high. We hate losing even a penny of money. It is very hard to not do that once in a while, but we would love to try to have our clients be largely unscathed by such a crash. Right now we are positioned in a way where that would likely be the case.
That also means you have to know when to get back in after a crash. That decision point is a very imperfect science as well. Like in ’08-’09 we got in a little too early relative to the low, but here we are six plus years later, seven years later, almost eight years later and you did not have to be exactly right to have done spectacularly well. I guess I would like to kind of go back just the recent pull back so far this year. We talked about how this year does not make a full picture of history. I would like to point out. Just this year we are not even a month into the year, and we have already clawed back over two years’ worth of gains in the stock market. Even if you look at the S&P 500, which has been the most lofty because of its capitalization weighted nature, where we are at right now and we were yesterday takes us all the way back to the end of 2013. For those listeners out there that might still be fairly heavily invested in stocks, I would invite you to do an exercise. If you have the ability to pull up a stock chart of the S&P 500 over the last 20 years, let us say, that is going to capture the big crash after the tech bubble and the big crash after the housing bubble. Take a look at that chart and ask yourself. Try to forget what you know about the recent news. Ask yourself: Looking at that chart, have I missed an opportunity to sell at the top? I think most folks looking at that chart would say "wow, there was a little wiggle from the top but I still have my chance to get out at or near the top for a big chunk if not all of my risk assets." That really speaks to the psychological difficulty of doing the right thing. Sometimes you just need to look at things from afar and realize, hey, that bounce I am waiting for to get back to an all-time high before I sell does not matter. I can still get out almost near the top, which is very hard to do.
Chris Martenson: It is a little hard, yeah. What we have seen is as I pull up that same chart John, what I see is one big bubble spike up into 2000 and then a very big pull back, which was the thing that got me off my duff and really looking at things. Then there was another big spike up to 2007 and then obviously another big pull back. Then there was another even more giant spike up. This time I am hearing a lot of talk though why this time is different. The central banks have our back this time. Certainly they have proven that to be true. What would cause you to flip this to think that maybe it is time to go long? If Draghi and Yellen came out holding hands and said they are going to jointly announce QE5, 6, 7, 8 together at the same time? What would possibly get you to think that there is more central bank juice left in this particular party?
Mike Preston: Chris, this is Mike here. There are a lot of different things that we look at that would make us want to invest on the way down. We keep talking about valuations. Valuations are very important. Valuations are terrible timing tools unfortunately. But valuations over the long term do matter. You look at those spikes back in 2000 and 2007, both were overvalued times. If you look at, for instance, the Shiller price-to-earnings ratio both of those times—actually in 2000 the Shiller P/E got up in the forties. In 2007-08, I believe it was into the mid to high twenties. Here we are in the mid to high twenties again. At least we were, near the top a couple months ago. Valuations have been really insane at the tops of those three peaks. Really it is almost like a whole shift to higher valuations that really started in the mid to late '90s and really existed throughout that whole period. Only once did we even pull back to a somewhat median or average valuation, and that was in the ’09 low where we pulled back to a Shiller P/E of around 15, which is still far from other bottoms. We have been living really the last 20 years or so in an era of higher valuations. It has been challenging to say the least to exit these peaks at the right time.
What we would look for, first of all, is a retreat in valuations. Now we cannot say that we are going to wait for a generational reset in valuation back to a Shiller P/E of seven or eight, which has not happened since 1982. We cannot do that. That could last one’s whole lifetime. What we can do is say that every time we were up at a 30 Shiller P/E, bad things happened.
We could look at other metrics too. The first thing we would look for is a retreat in valuations, number one. Secondly we would look at market internals, like breadth for instance. Breadth measures what types of stocks are leading the market up. How many stocks are making new highs versus the rest of the market? The breadth has been terrible in this market for the last couple years. Really it has been just a handful of stocks that have been leading this market higher, at least for the last year. 2015 was all about the FANGs – Facebook, Apple, Netflix, and Google. Other people say FANTA. They see stocks and they throw in Tesla for instance. You look at those stocks and you are completely disillusioned by what this market has done. Those stocks will look a lot like the nifty fifty in the seventies. They led the market up and almost certainly they will fall over time as much as the market, and probably more than the market over time just like the nifty fifty did. We would be looking for an improvement in internals, which would include like I said valuations and breadth.
We would look for a number of things. We would want speculation to recede as measured by New York Stock Exchange margin debt. At the risk of this answer getting long-winded, I guess from a mechanical standpoint I would respond to say: Some of these things we would want to see easing a little bit. You never really know. They are not just going to go away and revert back to normal. We are going to be doing a lot of things on the way down. Ideally we have a reset over time of let us say 30, 40, or 50% so that we can offer good opportunities to buy to our clients. We would do so. But we do not know if we are going to go down 70 or 80%. We do not know if we are going to go down 20%, bounce 20%, and then go down 40. What we will do is we will layer in different tranches like we did yesterday. We put a 10% slice in on a pretty fast pull back. We did so with appropriate hedges using options.
If we'd crashed the next day—which I guess is today now—we would have been able to adjust that original option. We might have doubled the position to 20%. If we crashed an additional 30% from there we might have increased to 30 or 40% and made some adjusting trades on the options. That is not to say that that is a risk-free strategy. We almost certainly would have been down a few percent on a portfolio basis if we fell that quickly. But we will be looking to layer in over time, so that is the approach that we can envision happening.
Chris Martenson: That is an excellent description of that. We are talking about equities here. We have talked about cash as a position. John, what about bonds in all of this? Is there anything to be done with bonds here except to consider them a moderately safe place to put money and maybe get a few percent out of this? Is there a larger play that still makes sense here?
John Llodra: Yeah, sure Chris I am happy to talk about that. I would just like to quickly add to what Mike just elaborated and you very nicely covered our views on things. This is in respect to your comment about what if the central banks pull out their bazookas again. I guess there might be some out there thinking that no matter whether valuations have retreated or all this other stuff that Mike talked about having moderated somewhat, is the fact that: Is the bazookas coming out in and of itself a reason to get invested, more positive, or optimistic about the stock market? There has actually been some great work done on that by folks like John Hussman. Basically, you can look at periods of time when central banks are easing or providing accommodative monetary policy. There are periods where that is all they need to do and markets levitate. There are also periods like ’08-’09 when they were aggressively easing interest rates, yet the markets continued to implode. John Hussman refers to this as the hinge.
Basically there are a set of conditions that when those conditions are present, things like Mike alluded to – deterioration of breadth, deterioration of market internals, a sudden shift of investor mindset from speculation to conserving capital. When these kinds of things are present, at least history says it almost does not matter what the central banks do. In fact, when they get more and more aggressive in those kinds of environments it may just convey greater desperation and panic on their part and investors run to the sidelines even more quickly.
Right here and now, where we are right now, the things that are present historically have not been supportive of central bank jawboning and action being a durable reason to be assuming that the market is going to fly higher. It would take a lot right now in changing those things for us to salivate and want to put down our defenses in any material way due to central bank desperation at this point.
Your question about bonds—real big picture, from a long-term investment class standpoint, the easy money has been made in bonds already. The last 30 years have seen an interest rate environment that has been nothing but downward. Interest rates from the early eighties right through today have done nothing but plummet, which is the main positive driver of bond returns. There is not mathematically much more room for them to go down, interest rates. So the upside in bonds is pretty limited.
Somewhat kind of scarily, the best case scenario for bonds is outright deflation. Long-term bonds and cash are the best places to be in a deflationary environment, which appears to be the scenario that is going on right now. Again the upside is pretty minimal. Sure there is a place for some bonds. Relative to cash, we would much rather hold a bunch of cash right now than be heavily invested in government bonds, which increasingly are becoming suspect of fiscal malfeasance on the part of governments all over the world.
Then there are of course some bond classes that are outright scary to be, like junk or high-yield bonds right now. Boy, they were great in the last several years. But in the last year and a half they have seen a bloodbath. We think it is just the start of something bigger. It started with some of the energy companies and some other sectors, but there seems to be some contagion going on there. We do not think it is by any means all clear yet in that sector.
Municipal bonds as a broad class have been okay, but there have been some very specific examples where they are getting pretty dicey. Puerto Rico is teetering on the edge of default. We all know what is going on in Chicago. So some municipal bonds are downright scary places to be right now. If we get further evidence that we are entering recession or even worse, municipal finances are not likely to do well in that scenario. We could see some more widespread issues with things like municipal bonds.
Emerging market bonds have been very volatile. They have sold off quite a bit. It has a lot to do with currency moves there and that's a very volatile sector right now.
A short conclusion to the long answer is we do not see a lot of upside in bonds. But sprinkled around the edges, some of the high-quality Treasuries and government bonds can be modest adders to value. We are starting to see a little bit of, insulting still, but modest interest on some short-term CDs. That is in part due to some of the Fed action on rates, but that fully has not flown through to savers quite yet and will not for a long time. We like cash, to sum it up.
Chris Martenson: On a risk adjusted basis cash is good. Cash is always king in an deflationary environment, particularly when you look at the risks. To summarize this, the prime reason that we at Peak Prosperity have been endorsing you guys is because of what we just heard here. It is obvious attention to all the details. You have the macro picture and the micro picture. But most importantly you have a diligent approach to risk management. What I really wanted to do in this podcast was to say, hey, not only do you guys talk about it, but you actually really do it. It is one thing to say you have a risk management strategy. A lot of people say that. But the numbers of people who actually have one that is in play and can be tested—and I do not think by any stretch we have been through the major test in this yet. But here we are. We are down 8.5% in this year, so this was a good time to circle around and say "how has it been working?" The answer is: It works. First, thank you for having that diligence and thank you for having that offering. I think risk management is the key thing for anybody who has money in the markets at this particular point in time.
Mike Preston: Thanks Chris. (This is Mike). We really do appreciate those comments. We live it because that is who we are. We apply these principles day in and day out. It has not been easy. Risk management has not been a very interesting topic for many to listen to or to talk about with us over the last couple of years, but... It is a funny thing; no one wants to talk about it until it starts raining. No one wants to talk about it until there is a problem, and then everyone wants to talk about it. We just kind of continue day-by-day. We keep applying the discipline and sticking with what we really believe is true based on our experience, knowledge, and our analysis. That is what we will keep doing. So far, as you said, we are down 8.5% this year. Who knows what will happen the rest of the year? We do think that from here forward at these levels in the market we are still dangerously over-valued, so we are going to continue to be very cautious as we presently are.
Chris Martenson: John, are there any final words to add to that?
John Llodra: No, I think Mike said it best. We try to do our job on a daily basis. Some times are harder than others, but we are guided by truth and data, and that is what keeps us going.
Chris Martenson: That is fantastic. Thank you for your time today gentlemen. We will make sure, as we always do when we have you on the show here, we are going to place a link at the bottom of the write-up accompanying this. If anybody listening wants to talk to you more, specifically about hedging and perhaps hedging in their own individual case with their own individual portfolios, we provide a way for people to do that. It is a free call to our listeners. There are no obligations whatsoever. It is hard to find a better deal than that. You just click on the link at the bottom of the podcast, fill out a short form, and the rest will take care of itself. If anybody is interested in that, I would encourage you to talk more specifically about your case because every case is individual. These gentlemen here have some really good heads on their shoulders and will treat you well. With that, thank you Mike. Thank you John. I cannot wait to have this follow up conversation in a few months.
John Llodra: Thank you so much Chris.
Mike Preston: Thanks Chris, and thanks to the listeners. Have a great day.