Kevin Smith and Tavi Costa - We Believe We’re In The Early Stages Of A Bear Market | #152

Episode Summary

Executive Summary: Crescat Capital’s Kevin Smith and Tavi Costa argue that U.S. equities are historically overvalued, global liquidity is tightening, and China is the central macro risk due to its debt bubble and likely yuan weakness. They frame the portfolio around three themes: short global equities, long precious metals, and short China-linked currencies/assets, while also highlighting selective longs like cybersecurity and genomics.

Main Topics: Crescat’s origin and investment framework (Priority: 5/5): Kevin Smith outlined Crescat’s evolution from value-oriented equity investing into tactical global macro, combining systematic models with discretionary judgment across equities, rates, currencies, and commodities. Tavi Costa described his role in building macro models and portfolio research. U.S. and global equity overvaluation (Priority: 5/5): The guests argue that multiple valuation measures—price-to-book, EV/sales, CAPE, market cap to GDP, and others—are in historically extreme territory, with their macro model near record overvaluation and late-cycle readings. China as the central global macro risk (Priority: 5/5): They present China as the world’s biggest credit bubble, emphasizing debt-to-GDP, bank assets, off-balance-sheet exposure, reserve-ratio signals, and the likelihood of yuan depreciation as the key transmission mechanism to global markets. Cycle timing, yield curve inversion, and recession risk (Priority: 5/5): Beyond valuations, they stress timing indicators such as global yield curve inversions, falling central-bank liquidity, and U.S. rate/credit stress as evidence that the market is late-cycle and a bear market may already be underway. Precious metals as safe haven and portfolio hedge (Priority: 4/5): Gold and mining stocks are portrayed as a major long thesis, supported by historical behavior during past cycle turns and relative valuation versus equities and silver. They see precious metals as a hedge against policy response and market stress. Additional sector and regional shorts and longs (Priority: 3/5): They highlight short ideas tied to China spillovers, including Canadian housing, Australian debt, utilities, and some emerging markets, while favoring cybersecurity and genomic innovation on the long side.

Key Arguments: Their 16-factor macro model combines valuation, economic, and technical signals and currently indicates record-high overvaluation and late-cycle conditions. U.S. equities are expensive by nearly every major valuation yardstick, and profit margins/free cash flow margins are likely peaking late in the cycle. China is the largest credit bubble they have studied; bank assets, debt levels, and off-balance-sheet exposures make a disorderly adjustment plausible. The yuan is vulnerable because China’s current account, reserve requirements, and stock/currency correlations point to stress and potential devaluation. Global liquidity is deteriorating as QT and central-bank balance-sheet growth turn negative year over year, which they believe is bearish for risk assets. Yield curve inversions should not be dismissed as a slow-moving signal; in several historical episodes, bear markets began before recessions were officially recognized. Gold and precious metals are attractive because they tend to outperform as business cycles peak and policy eases into crisis. Selective longs like cybersecurity and genomics are supported by strong secular growth even in a slowing economy. Investors should think tactically, not just buy-and-hold, because current valuation and cycle conditions resemble major historical tops. China-linked regions such as Canada and Australia may be vulnerable through housing bubbles, debt, and capital inflows/outflows tied to China.

Data Points: Macro model factors: 16 factors - Their global macro model combines valuation, macro timing, and some technical indicators. Valuation indicators: About 4 of the 16 factors - Kevin said most factors are timing-related, though Tavi also cited roughly eight valuation measures separately. Macro model history: Back to 1987 - The model’s score series goes back to 1987. Model distance from record overvaluation: About 2 percentage points - They said the current score is roughly two points from record overvalued levels. Countries with 30-year yields below Fed funds: 15 economies - They noted a global rate distortion where long yields are below overnight U.S. rates in many countries. Debt-to-GDP in major historical bubbles: ~245%-250% average - Average total debt-to-GDP in prior major credit bubbles like Japan, Asia crisis, housing bubble, and Europe. Current global debt-to-GDP comparable set: ~269% - Their 2018 comparison showed a higher average debt burden than prior bubble episodes. Chinese bank assets relative to GDP: Above 300% - Their estimate of on-balance-sheet Chinese bank assets relative to GDP. Off-balance-sheet Chinese assets: ~$45 trillion - They cited China’s own financial-stability disclosures as evidence of large hidden exposures. Chinese bank asset growth since GFC: Close to 400% - They said asset growth since the global financial crisis dwarfs the U.S., Japan, and eurozone. Median Chinese stock decline in late 2018: Close to 40% - Used as evidence of stress in China’s equity market. Global equity short stance duration: About 2 years - Their hedge funds have been net short equities for roughly two years. U.S. market cap to GDP: 140% - They described this as the highest ever, above the tech bubble. U.S. twin deficits: Close to 8% of GDP - Cited as a bearish signal for equities, and possibly fixed income depending on interpretation. Consumer confidence divergence: Near-record; 96th percentile overall - Present situation vs expectations divergence is near an extreme similar to 2000. Utility sector free cash flow: Negative for several years - Part of their bearish case on utilities as a supposedly defensive sector. Yield curve inversion coverage: Above 50% of possible U.S. yield-curve spreads - Their broader yield-curve model shows more than half of the curve inverted, comparable to past major peaks. U.S. corporate profits/margins: Record profit margins and record free cash flow margins - They see current margins as cyclical peaks likely supported by late-cycle tax cuts. U.S. corporate debt: Record levels - They argue high leverage amplifies downside risk if growth slows. NVIDIA holding performance: About a 5-bagger - Kevin cited NVIDIA as a memorable long investment from around $20/share. Chinese currency move in 2015: Mini-devaluation in August 2015 - Tavi referenced an early China currency short thesis that benefited from the devaluation shock.

Pivotal Quotes: "“We think that US stocks and global stocks in general, but mostly US are historically overvalued…”" — Tavi Costa: Introduced the firm’s three highest-conviction themes and the bearish equity view. "“We believe we are in the early stages of bear market.”" — Kevin Smith: Kevin explained why Crescat remains net short equities despite recent rallies. "“The macro trade of the year… is being long gold in Chinese yuan terms.”" — Tavi Costa: Summarized the firm’s preferred expression of the precious metals and China theme.

Implications: Listeners should hear a strong cyclical warning: Crescat expects weaker equities, a stressed China, and stronger gold. The practical takeaway is to consider tactical defense, more hedging, and selective exposure to secular growth and safe-haven assets.