September 30, 2016

Quarterly Investor Letter, Q3 2016

Also see Crescat Capital 2Q16 Investor Letter: China QE Dwarfs Japan And EU

Q3 hedge fund letters

Dear Investors,

[drizzle]Here we are again at the peak of another financial asset bubble. An important macro indicator based on the valuation of US-held global financial assets is signaling extreme caution. The chart below measures the valuation of all global financial assets (stocks, bonds, and cash) owned by US persons relative to their after-tax income. Unsustainable extremes in this ratio have marked the turning points from bubbles to busts of the dominant macro trends of our time.

As one can see in the chart, the intermittent peaks in financial asset to disposable income levels that we point to correspond with watershed moments in US and global financial market history, such as the collapse of the London Gold Pool in 1968, which ended US dollar convertibility to gold and triggered a secular bear market for US Treasuries. This indicator also peaked along with the Nifty Fifty Stock Bubble in 1972, the Tech Stock Bubble in 2000, and the US Housing Bubble in 2007. Each peak preceded a major financial crisis and US economic recession. Just last year, we reached new record levels of financial asset to income imbalances with bubbles globally in essentially every financial asset class.

If this indicator did in fact peak as it appears at the end of Q1 2015, when market historians look back, how will they define the current financial asset bubble that we are now descending from? Is it a global financial asset bubble? Perhaps that term is too broad and general even though it is probably true. Is it a stock market bubble or an index investing bubble? Very possibly both. The S&P 500 is still struggling to convincingly break out above the 2100 level reached in Q1 2015 and could be ripe to break down. See our twelve fundamental charts on the S&P 500 towards the end of this letter that warn of historic leverage and valuations. Is it a fixed income bubble? Have Treasury bond yields finally bottomed? Certainly on a real return basis going forward, bonds are in a massive bubble right now. Also, bi-partisan US policy makers have fiscal stimulus plans for 2017 which could drive yields higher on Treasuries. See our six fundamental charts at the end of this letter on utility stocks, which are bond proxies and are the most overvalued sector in the S&P 500 according to our model. Is it a global fiat currency bubble? Yes. Certainly. Gold is historically cheap relative to the global fiat monetary base and is in a renewed bull market that began at the end of 2015. Is it a global central bank bubble given the record money printing and ultra-low interest rates that just can’t seem to get inflation and economies cranking again? Definitely. Global central bank monetary stimulus has only served to date in creating the biggest financial asset bubble of our lifetimes.

But there is still one element behind the financial asset bubble that we haven’t mentioned yet that may be the linchpin. Of course, it’s China. China’s economy features prominently in the recent peaking of the financial asset to income indicator in our chart above. The Chinese stock market had both a melt up and melt down last year as the indicator peaked. Also the Chinese yuan devaluation in August 2015 was one of the key global macro events of 2015 and happened just after this indicator peaked. Furthermore, the Chinese were selling their foreign reserves aggressively in 2015. In the name-that-bubble contest, Crescat is first and foremost naming this bubble and crisis precipitator, the China Bubble. We have been writing about the Chinese Currency and Credit Bubble in our investor letters for the past few years. This bubble has only just started to burst. It is perhaps the biggest financial bubble of our lifetime, and its bursting will no doubt have a contagion effect on the rest of the world. Most investors probably do not realize it yet, particularly given the convulsive, reactionary rally that we have had in stocks since the February lows, but we have very likely already entered a new crisis period for financial assets induced by China.

The tandem selloff that recently took place in stocks and bonds represents a major warning signal for the financial markets in the short term. On September 9th, the S&P 500 sold off by 2.5% at the same time as German 10-year Bunds sold off (from an all-time high) in a seven standard deviation move. US Treasury bonds also sold off that day, continuing a downtrend that began July 6th. Japanese sovereign bonds have been selling off consistently since topping out with yields of minus 30 basis points (-0.30%), on July 27th. Before September 9th, the last significant tandem selloff in stocks and bonds in the US was on December 3rd, 2015, as shown below in the scatter plot of the daily performance of the S&P 500 and Barclays Long Term Treasury ETF over the last year.

The 12/3/15 tandem selloff kicked off an ugly 2-month period for stocks to close out 2015 and begin 2016. From 12/3/15 to 2/11/16, the S&P 500 dropped by 10.4%. We want to remind our investors that the Crescat Global Macro fund gained 8.8% net over that same period. As the chart shows, a tandem stock and bond selloff just happened again, twice in September. Once again, this could portend a difficult period for global stocks in the near term. We believe Crescat is well prepared across all of our strategies for such an environment.

The recent surprise selloff in the global sovereign bond market across US Treasuries, Japanese Government Bonds, and German Bunds at the same time raises the suspicion that China is in the market selling its foreign reserves. The People’s Bank of China holds its foreign reserves primarily across these three instruments, but also in gold. The PBOC has been a widely known buyer of gold over the past several years but in an undisclosed amount. In the ugly period of the most recent December and January, China sold a record $206 billion of foreign sovereign bonds over those two months while gold rallied. At the same time, its currency, the yuan, was declining. The risks in the global financial markets as a result of the Chinese Currency and Credit Bubble are substantial. We are well positioned for these risks at Crescat within the constraints of each of the three Crescat investment strategies.

In addition, there has been a perverse phenomenon going on in the markets since the February global equity market lows that points to extremely frothy market conditions today. Many of the stocks with the poorest fundamentals and highest valuations based on our time-tested fundamental model have been rising the most. Indeed, investors have been chasing passive indexing strategies and selling hedge funds after a seven-year bull market and corresponding stretch of underperformance by large hedge

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