Interview

«The Next Bear Market Has Already Started»

The stock market is back to record-breaking levels. But for Kevin Duffy, head of hedge fund Bearing Asset Management, cracks are forming beneath the surface. The contrarian investor says why he advises increased caution and how he positions his portfolio for a downturn.

Christoph Gisiger
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Once again, Wall Street is in a party mood. On Thursday, the S&P 500 closed at a new record high for the sixth time in a row. Fears of inflation and rising interest rates seem to be gone. Risky assets are back in vogue.

Kevin Duffy doesn't trust this situation. The founder of hedge fund Bearing Asset Management and editor of the investment newsletter «The Coffee Can Portfolio» spots clear signs that speculation in the markets is becoming increasingly frenetic. He warns that one mini-bubble after another is bursting: from meme stocks like GameStop and AMC to «hot» growth stocks like Tesla to cryptocurrencies.

«It feels like the peak in the broad market was in the middle of February,» Mr. Duffy says. «This is classic topping behavior: At the surface, everything looks reasonably ok, but under the surface you have all this damage that’s being done», he adds.

In this in-depth interview with The Market NZZ, the straight-talking contrarian discusses the warning signals he looks out for, how investors can protect themselves against a market crash, which stocks he believes have potential even in a difficult environment, and why gold is a core investment in his portfolio.

What’s your take on the current mindset of the financial markets?

I think we’re in a rotation phase right now. All of the speculators – young people and day traders – have been drawn into the casino, and they’re not going to leave until they’re flat broke: When the poker table shuts down, they move to the roulette section, and when that stops working, they go to the blackjack table. This kind of wild frenetic rotation is not unusual at the top of bubbles.

Yet, the major averages are all at or near record-highs.

In my mind, the next bear market has already started. It feels like the peak in the broad market was in the middle of February. So we’re now four months into the bear market, but people are just looking at the popular averages. This is classic topping behavior: At the surface, everything looks reasonably ok, but under the surface you have all this damage that’s being done.

What do you mean by that?

The formation of bubbles is like that of islands when the earth’s plates slowly move over a hot spot. The liquidity flows from one area to another, and you get this series of rolling little bubbles. This year, we had the obsession with meme stocks in late January, and then we got «Neomania», a term coined by Nassim Taleb which refers to this infatuation with anything that’s new. Essentially, companies like DoorDash, Airbnb or Tesla that are very disruptive but are going to lose money well into the future. And of course, you had these huge inflows into Cathie Wood’s ARK Investment ETFs. All of that, along with hot IPOs and celebrity SPACs, peaked in mid-February, and since then these stocks have had serious corrections. Next, you had the crazy action in commodities with lumber prices going through the roof, excuse the pun. After that, we had the cryptocurrency bubble in April.

It looks like these little bubbles did burst as well. Lumber prices have pulled back significantly, and bitcoin has lost around 50% since it peaked in mid-April. What’s going to happen next?

As I said, the gamblers are not leaving the casino. Now, we see a second wave of the huge run-up in meme stocks like AMC Entertainment. To me, AMC is much crazier than GameStop. At least with GameStop, you had Ryan Cohen coming and taking a significant stake in the company. Since he was the co-founder of Chewy and very successful in ecommerce, this is a lot different from the case of AMC. AMC’s free cash flow went deeply negative, and they’ve just filled that gap by issuing stock. Their share count has gone up from 105 million to over 450 million, and a lot of stock was issued at lower prices. So this is a whole order of magnitude crazier than the first wave of meme stocks in January.

AMC is supposed to be a winner of the re-opening of the economy. Why do you think this movie won’t have a happy end?

The pandemic obviously killed their business. But you also have to look at the arrangements they have with the content providers. The dynamic there has changed, and it’s not necessarily ever going back. The content providers have become even more independent of the theaters. So fundamentally, AMC’s business wasn’t just impacted in the short term from the shutdowns, the pandemic has accelerated the long-term decline that was ongoing before.

So what’s the end game going to look like?

The gamblers start losing, and that’s a tell-tale sign. They also get more and more desperate since compulsive gambling is a progressive disease. This means speculation gets progressively wilder in the last stage of a bubble. Here’s an important data point: According to the most recent data, margin debt ticked up another notch to more than $860 billion in May. These are absolutely staggering numbers. For comparison: At the beginning of 2020, margin debt was $580 billion, and in March it went down to around $480 billion. That’s $100 billion in liquidation followed by $380 billion in new margin debt. All of the positive things, the conservatism that we started to see last year and the liquidation of the most leveraged traders, all that has been reversed.

As a professional investor, you’ve witnessed a fair number of bubbles in the past. How does today’s mania compare to previous excesses?

When I started my career in 1985, I was still a little wet behind the ears when the crash of 1987 happened. Before the meltdown on Black Monday, there was a fair amount of bullishness from a sentiment standpoint, and then we went to extreme pessimism: absolute pitch-black. Almost everybody in the industry was paralyzed with fear, mutual fund cash levels went up to record levels. They say bull markets climb a wall of worry. That massive wall of worry which was built up after the 1987 crash didn't dissipate really until the mid- to late nineties, so it took a good ten or twelve years. But this time, after the panic in March 2020 a similar swing in sentiment took place in just a year.

One reason for this swift swing in sentiment is probably that the central banks have rushed to the rescue and flooded the markets with gigantic amounts of liquidity.

That’s certainly a factor, but there have been others. One is that we’ve had a long running bull market, so everybody has been conditioned to think that this is a game, that it is a sure thing. Investors are convinced that they have the Fed at their back, and there is no downside whatsoever. And then, everybody was locked down and receiving stimulus checks. Many took that money to bet on stocks, creating a perfect storm which funneled huge flows into these speculative stocks.

Then again, so far, the buy the dip approach has worked out pretty well for investors. What could go wrong?

I think it’s the harsh reality that bubbles are incredibly destructive. What defines a bubble is a false belief system, a commonly held misconception. Bubbles can also be deceptive; they tend to change their spots. The bubble in 2000 was fueled by the idea of the first mover advantage. Then, the real estate bubble was based on the belief that home prices can only go up, that you can’t have a national downturn. But in this bubble, the false belief is on a whole different level. There is a general belief that the government is the solution to all problems. This is much broader than just the financial markets. We’ve seen it in dealing with the coronavirus. The government solution was to throw trillions of dollars at it and lock everyone down. It was a very heavy-handed response.

What could burst that main bubble?

What brings down this house of cards is the realization that the government stimulus didn’t work, that it simply pulled forward future consumption. What happens once this shot of the drug wears off? What do we have left? There’s also the misallocation of resources, and not just the engorging of the government parasite. We’ve talked about AMC. What should they be doing? They should probably be downsizing, coming up with alternative plans. Instead, they’re looking at expanding. The price signals that economic actors need to direct them have been completely distorted.

So what could be the trigger that pops the «everything bubble»?

Jesse Livermore, the legendary but ill-fated American stock trader, once said that «a market does not culminate in one grand blaze of glory. A market can and does often cease to be a bull market long before prices generally begin to break.» There might be some coincidental event around the time a bubble bursts, but I believe most tops are a process. These things happen through exhaustion. Another aspect is that some of the most marginal areas tend to crack first. We saw this with the dot-coms imploding in early 2000. Likewise with the subprime lenders in early 2007 when they completely disintegrated in a very short period of time. We might see something like that. It could be the cryptocurrencies, meme stocks or money-losing IPOs – hard to predict. After the bubble bursts, it will be obvious in hindsight.

You have a lot of experience when it comes to short selling. How can one bet against this market when we see stocks like AMC going bananas without any fundamental reason whatsoever?

It’s not for everyone. But if you feel comfortable with the valuations of what you own, and you’re concerned about economic risk as I am, then it makes sense to have some insurance to hedge your portfolio. Basically, there are two ways: One is the very simple way which is to buy bear funds on the major indices. That’s what I’m doing with The Coffee Can Portfolio, my investment letter. We also have a position in a bear fund on the high yield index.

And what would you suggest for a sophisticated professional investor?

You can take advantage of this rotation game which worked beautifully in 2007 and 2008. When you get one of these hotspots and the bubble blows up, you look for short opportunities there. And when that bursts and it’s replaced by another mini-bubble, you try to short that. So you just keep on rotating. But you have to be aware that it’s much more difficult than in 2000 and 2007, because the basic problem with short strategies is the central bank’s printing press. So you might be right on your short theses, but you get taken out in a body bag if these jokers just print some insane amount of money and prices explode.

What's your general advice for investors who want to invest their money in a reasonable and prudent way in this challenging environment?

If you want to live off the grid and live off of fruits, berries or coconuts, that’s one thing. But if you want to accumulate wealth or protect it, you’re in the investment game. You don’t have a choice. So you have to ask yourself: Who are your competitors out there? First of all, I don’t want to compete in the short-term trading arena with high frequency traders like Ken Griffin, the CEO of Citadel. That’s like competing against Tiger Woods on the golf course. The reason why guys like Griffin are doing so well is because you have a bunch of amateurs trying to compete with them.

So what’s your investment strategy then?

We want to focus on the long-term. That alone, especially when we have all these amateur traders, is going to give us an edge. A lot of it goes back to some of the ground rules of The Coffee Can Portfolio: avoid the crowd, stay disciplined, try to avoid emotional reactions. Another edge is to see the world through an Austrian or non-interventionist lens, to understand that there is no free lunch.

Where do you spot opportunities in this regard?

Even if the craziness goes on longer, I want to own defensive companies. If the «everything bubble» finally bursts, and we go into a recession, I want to own companies which may not be recession proof, but are going to be somewhat recession resistant. Also, I want to be aware of the big picture trends that are playing out regardless. For example, I believe active management is not dead and will make a comeback. The crowd has piled into passive investing, so you have a whole contingent of investors who are making decisions not based on fundamental value, but just a one-way bet on the S&P 500. Looking at fundamental value, there is a big difference if a stock is inside or outside the S&P 500 – and that leads you to pockets of opportunity.

What sectors or industry groups look interesting against this backdrop?

Last year, what was really on sale were retailers, basically anything that got shut down. I have been following retail for a long time, but I have never seen anything like this before: These stocks were absolutely thrown on the trash pile. Looking back, from a contrarian standpoint, it was probably a sign that the economy was not ready to go into the tank. Of course, retail stocks have rallied back and they’re not the bargains they were twelve months ago. But a lot of them are still cheap.

What would be an example for an attractive retail stock?

I like Dollar Tree. They basically have a duopoly in the dollar store space along with Dollar General in the US. In mid-2015 they made a bold move, acquiring their slightly larger, but less profitable competitor, Family Dollar. The goal was to turn things around, but the early enthusiasm proved to be overblown. So the stock just treaded water for a long time. And what happens when things take a long time? Investors get tired, they move on to far more exciting areas like GameStop or AMC. Anyway, Dollar Tree is a very defensive business, it’s essentially Amazon proof, and they have been heavily spending on renovating the Family Dollar stores. Now, operating margins are improving, but the company is not getting a lot of credit. They generate strong free cash flow already, and if they’re able to just keep on improving, this stock should provide protection in a bear market and some upside if the bull market continues. What’s more, two like-minded investors, Oscar Schafer and Charles Akre, have a position in the company, which gives me even more comfort. Both follow a highly concentrated, low turnover, value-based approach.

When we talk about defensive stocks, the healthcare sector comes to mind as well. What’s your take on that space?

I try to tailor the portfolio to have as many tailwinds as possible. One of the themes with Dollar Tree is that the middle class is being squeezed in the United States. The flipside of that is the expanding middle class in places like India, China and Africa. The genomic revolution is another tailwind. It’s a megatrend with respect to the aging population around the world. One beneficiary and a long-term holding in The Coffee Can Portfolio is Regeneron Pharmaceuticals. What's more, we’re zigging while the market is zagging: Regeneron was a Covid winner, but now the crowd has gravitated to the Covid losers, the companies that were locked down. The attention has shifted, and as investors we want to be taking advantage of that. We want to be looking at the types of stocks that are somewhat out of favor.

Another such area that seems to be out favor are precious metals and mining stocks. What are your thoughts on that sector?  

I like the area. We actually did add to positions when gold was down around $1700 per ounce, so we’re pretty flush in terms of our positions. Sometimes things get all lumped together, but commodities are not a homogeneous group. On one side, you have energy and industrial commodities that are economically sensitive. To me, gold is a different animal, more of a monetary commodity. That’s why we’re not just invested in gold mining and royalty companies, but hold ETFs that own physical gold and silver as reserves, or a surrogate for cash.

And what’s your case for gold?

No one can predict the future with certainty. That’s why I look at multiple paths, different scenarios with multiple twists and turns. I think there's at least a 10% chance that we could ultimately have a hyperinflation over the next ten years. So we have to be prepared for that possibility. But what happens if we get a scenario with a global recession first? In this case, it’s highly likely that commodity and energy prices decline. If gold stays flat or even down slightly, the miners should benefit as their cost structure falls more than the price of gold. They already generate strong free cash flows, and the industry is much more conservative than it was ten or twenty years ago, much more focused on profitability. So we have the best of both worlds: Not only do we have a cash flow generative business and a disciplined industry that’s not destroying capital, but we also have an option value if something were to go badly wrong with the great monetary experiment.

Kevin Duffy

Kevin Duffy is a battle-proven contrarian investor and veteran in the risky business of short selling. He co-founded Bearing Asset Management in 2002. He was a vocal critic of the 2007 credit bubble, successfully shorting many of its most aggressive players including Countrywide Financial and Bear Stearns. Prior to Bearing, Kevin co-founded Lighthouse Capital Management and served as Director of Research from 1988 to 1999. He chronicled the excesses of the Japan and technology bubbles of the late 1980s and the late 1990s. Kevin Duffy bought his first stock at the age of 13. He has a passion for Austrian economics. He is the author of the popular Notable and Quotable blog and The Coffee Can Portfolio.
Kevin Duffy is a battle-proven contrarian investor and veteran in the risky business of short selling. He co-founded Bearing Asset Management in 2002. He was a vocal critic of the 2007 credit bubble, successfully shorting many of its most aggressive players including Countrywide Financial and Bear Stearns. Prior to Bearing, Kevin co-founded Lighthouse Capital Management and served as Director of Research from 1988 to 1999. He chronicled the excesses of the Japan and technology bubbles of the late 1980s and the late 1990s. Kevin Duffy bought his first stock at the age of 13. He has a passion for Austrian economics. He is the author of the popular Notable and Quotable blog and The Coffee Can Portfolio.