What's the next big short? The question was posed this week to two noted investors known to have an eye on the downside--David Tice and Harry Rady--at Financial Advisor and Private Wealth magazines' Innovative Alternative Strategies conference in Chicago that was attended by more than 400 people. And their short answer? The U.S. economy.
Tice, who started the Prudent Bear Fund (now the Federated Prudent Bear fund) in 1996 and has long been one of the investing world's most accomplished short sellers, was characteristically the more bearish of the two. To him, one of the biggest red flags is the country's excess debt. Specifically, he said we're heading for a heap of trouble because total credit market debt is about 380% of the U.S. gross domestic product.
Tice, who's currently the bear market strategist at Federated Investors, subscribes to the school of thought that excess credit creates asset inflation and out-of-whack balance sheets--a combination that ends badly. "We're set up for a significant secular bear market that will last a long time."
He puts the odds for a double-dip recession at 95%, and said some of the potential negatives include unimpressive results from the federal stimulus program and a weak job market. "Most people who were hired during the past eight months were census workers," he said.
Rady, chief investment officer and portfolio manager at Rady Asset Management, agreed with many of Tice's premises--but not entirely. "We're not that bearish," he said.
Rady's firm manages more than $250 million in long-only and long-short strategies in the form of mutual funds, limited partnerships and separately-managed accounts. He said he was perplexed that investors "absolutely ignored" the many risks and vulnerabilities of the market during last year's meteoric rise in equities from the March lows.
He's also amazed at how precarious the U.S. financial system has become due to it's bloated balance sheet. "A few years ago credit default swaps on U.S. Treasuries didn't exist," Rady said. "Now they do, and people are putting their money where their mouths are and buying insurance against a potential default on U.S. Treasuries."
Rady worries that excess government debt could create a combination stagflation/hyperinflation scenario where the economy struggles but debt concerns cause interest rates to rise.
And Rady said another unpleasant scenario centers on a potential trade dispute with China, which is a big holder of U.S. Treasuries. "I argue that it [trade dispute] could spook the markets and drive long-term rates as much as double, which could seriously impact the economy and the markets," he said. "We think there are dozens of plausible scenarios like that that aren't being discounted today."
But rather than running for the hills, Rady sees opportunity in the uncertainty of a choppy market where the Federal Reserve is running out of ammo to get it back on track. "We view a volatile environment as opportunistic for our long-short strategy," he says.
Rady said he looks for asymmetric risk/reward ratios both on the long and short sides. On the downside, Rady intimated that U.S. Treasuries present an opportunity. "We think long-dated Treasuries provide a very attractive, asymmetric risk/reward ratio where the rates can't go much lower but there are dozens of scenarios where they can go significantly higher."
On the long side, he says he buys dominant, world-class companies selling below perceived value. "Buying high-quality companies that aren't in vogue and shorting low-quality companies when they're in favor takes a significant amount of risk out of the equation," Rady said.
One company he likes as a long investment is Sanofi-Aventis, the French pharmaceutical giant that's trading at roughly half of its traditional price-to earnings multiple. Rady believes one of the reasons is simply because it's a European company.
"But it's a multi-national company," he said. "It's a good example of an asymmetric risk/reward ratio."
Another such example on the long side, he said, exists in the natural gas industry--particularly the drillers whose underlying stocks have been hammered by industry oversupply and low prices. He noted that many natural gas drillers are trading at historical lows.
"Historically, this is a self-correcting industry, and we think it will happen again," Rady said. "We think many E&P (exploration and production) stocks could be doubles and triples over the next 24 months."
As for Tice, he said he has been long on gold, silver and other mining companies.
"On the short side, we're like a kid in the candy store," he said, adding that compliance prevents him from naming names. But he specifically mentioned consumer discretionary stocks and "some of the trash that went through the roof in '09" as prime shorting candidates.
One of the financial advisors at the conference, Fritz Folts, a principal at Windward Investment Management in Boston, sees merits in the double-dip argument even if he doesn't fully subscribe to it. "Double-dip isn't our number one scenario, but our scenario could be wrong so we need to have things in our portfolio to protect us if that occurs."
Folts said one of his firm's top-ranked holdings is the Vanguard Dividend Appreciation exchange-traded fund (VIG), which tracks the stock performance of companies with consistent year-over-year dividend growth.
Windward, which actively invests across a broad range of global assets via ETFs, exchange-traded notes and registered funds, has long been big on China. But Folts said they now worry the government could throttle growth with overly aggressive interest rate hikes aimed at taming inflation.
"Right now, I'd say China is on probation" [in our portfolio], Folts said.
He added that one area Windward likes a lot is emerging market bonds, where the yields are fat and the balances and surpluses in many of those countries are stronger than in developed countries. "Their currencies have opportunity to appreciate, and if their interest rate environment changes you could win there, too," Folts said. "It's a relatively safe place to pick up yield and get some potential return. It's much better than piling into U.S. Treasuries, which right now doesn't make sense to us."