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A Player-Turned-RIA on 2021’s Super Bowl and the Market Roller Coaster Ahead

James McDonald, CEO of Hercules Investments, is using equity index options to profit from an expected surge in volatility and market swings.

One hundred million viewers are expected to tune into Sunday’s Super Bowl between the defending champion Kansas City Chiefs and Tampa Bay Buccaneers.

James McDonald will surely be watching.

The CEO and chief investment officer of Hercules Investment, a Los Angeles-based RIA, saw his college football career cut short by a catastrophic knee injury that sidelined him for 15 years. In 2005 he purchased the Houston Wolverines (the Texas Wolverines today), a semi-pro football team, and played for 13 years. Today, his ambition is to own a NFL team. More on that later.

McDonald was CEO of Index Strategy Advisors from 2010 until 2019, when he founded Hercules, which offers market neutral portfolio management, while specializing in high-growth equity index options for clients.

Having traded more than $10 billion worth of options in his 26-year career, McDonald says speculative excess is rampant, citing bitcoin, the SPAC boom, Reddit/GameStop, and elevated valuations. 

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He argues the stimulus package will fail to rehabilitate the economy and thinks investors are too sanguine about the vaccine’s rollout, citing logistics and trust issues surrounding the vaccine.

McDonald, who graduated from Harvard University with an economics degree, expects the Dow will tumble more than 50% to 15,000, a prediction he has made several times since March 2020, before surging to new highs this year.

Below are excerpts from our Jan. 28 discussion, edited for length and clarity.

Hi, James. Let’s start with your macro view.

The equity markets have behaved puzzlingly well in 2020 with the backdrop of a global pandemic and lots of uncertainty around the evolution of the coronavirus and its impact on small businesses, households, and way of life. Despite the challenges of Covid, equity markets have pushed to all-time highs on most indexes in a fashion that would suggest there is no risk in the market.

Of course, we know that there's tremendous risk, not just to our health, but to the sustainability of small businesses, to the credit and economic security of households and to the outlook for how we will move forward past the pandemic. With this risk in the market, many individual investors have to count on either continued paid stimulus or continued paychecks and loans for small business relief. And we know that this isn't how a strong economy operates.

What should advisors know about your firm and how you can help them?

Hercules Investments provides a growth option for investors who need gains and growth, but we offer an element of downside risk protection because equity markets are disconnected from what we know is GDP contraction, debt, and all the uncertainty that comes along with a mutating virus. We are able to provide uncorrelated growth, meaning our strategies do not depend on equity markets continuing to rise in order to accomplish gains.

Our strategies offer downside protection and even potential upside gains with protracted market downturns. We do this because we invest in index options, which give us the flexibility to purchase contracts that rise in value when markets fall and to own very misunderstood and often overlooked asset class volatility. Volatility itself could be owned through a number of securities.

More specifically, how do you do this?

Our ability to monetize volatility is exceptional as evidenced by our winning WealthManagement.com’s 2020 Wealthies Award as top Alternative Asset Manager. We deliver these strategies through NFLHX. It is a risk-hedged growth mutual fund that captures market appreciation and has the potential for great gains when markets fall. The fund is for qualified investors only, and as such mimics many of the features of a hedge fund strategy. Unlike hedge funds, however, a mutual fund is accessible to individual investors and their advisors in a very transparent package. Our emphasis is on index options investing around the U.S domestic large indexes, specifically, the S&P 500, the Russell 2000, and Nasdaq 100.

We are partnering with Nasdaq to put Nasdaq 100 Volatility Index (VOLQ) into our portfolio in a way where investors who have realized great gains from tech can rest assured knowing that in the event of a potential market downturn, our fund will be able to sustain the impact of a declining market and should provide upside. Our specialization in volatility is what sets us apart because there are many funds and strategies which offer potential gains in a declining market, but as passive indexes or passive strategy, they are bound to lose money when markets are flat or rising. In summary, NFLHX provides direct access to risk hedged growth adding a layer of insurance to a portfolio that has appreciated with the market.

This funds fees accelerate when its performance accelerates. Its two and 20 (fee arrangement) ensures that our portfolio management is in alignment with the profit objectives of the client. When we perform well for the client, we perform well for ourselves.

Describe the ideal client profile. And while recognizing that each investor’s needs are distinct, on balance what percentage of a portfolio should this comprise?

This fund is for qualified investors only. The ideal client would have a portfolio of stocks that have appreciated with the market and while offering great growth potential is susceptible to a market downturn. In a portfolio with a beta of one, one would enjoy virtually 100% downside protection with an allocation of 15% to the Hercules fund. And so, if the market falls say 10%, our allocations will potentially offset the losses in the long only portfolio.

However, as markets continue to thrive, our fund will not follow the path of other downside protection strategies, passive only strategies, which fall precipitously in rising market. If markets rise, our fund is managed to match or exceed that growth based on our ability to go long or short with index options. It’s an all-weather strategy.

Do you still have a 15,000 target on the Dow?

Yeah. I think all the equity markets are so overstretched that when a risk element enters the market, the selling will be violent and accelerated. But I think that the market will rebound and potentially finish the year slightly higher. I think we will have another risk event that pulls the market down. And I think that that will trigger selling of portfolios that have had extensive gains, particularly in the past six months. I think we will retest the previous lows of last March before buying comes back in. Very few recessions and market collapses have recovered in the time period that we saw in 2020.

To be clear, you expect a risk event this year will take the Dow down to 15,000 but by year end it will finish higher than today? That would be a doubling from the low.

Yes.

What’s the bear case predicated on? Because bulls point to loads of liquidity, low rates, and solid earnings and guidance. The economy is slowly reopening and more vaccines are reaching people.

The bear case is that the effects of the shutdowns haven't fully been realized yet. It’s like a freight train that can't come to an exact halt without a crash. And so, we had that crash and then the desire and the interest in moving back forward. It takes  time to get back up, but we have had renewed waves of lockdowns in the fall and layoffs. And when we look at unemployment now, we say it's recovered, but the recovery hasn't brought sufficient growth. And so, equity market prices are assuming earnings that aren't there. Now, there are a handful of companies that have flourished in the Covid era, but it's a handful of companies. There are hundreds of companies in the small cap space that don't have the cash to pay their debt.

And debt has spiraled over 50% higher to GDP than where we were last year this time. Employment levels have increased slightly, but we are artificially keeping our economy going with stimulus checks and obviously all of the Fed's actions. And so, this is artificial. Let's call it artificial income and artificial credit for small businesses that are keeping the economy alive. What the Fed did was to protect the economy from going into the abyss. But stimulating growth is impossible if the economy isn’t open. Vaccinating the public will not happen as quickly as most expect. And even still, there is the risk of mutations, the continuation of sickness, hospitalizations, and fear will cause stagnation for the reopening concept. And what we're seeing now is bull market enthusiasm and all types of signs of bubbles in asset prices.

This inflation will cause interest rates to rise in the medium term or long term and the necessary pullback in the markets will be a result of investors taking risk off the table. The potential for growth is there, but the conditions for growth are not because we are artificially providing income. Small businesses are suffering tremendously, and they're always going to be the engine of growth for the economy. It's not a doomsday picture, but markets are priced right now as if all economic engines are fully up and running.

You’re describing a giant disconnect between the markets and small businesses that are in a world of hurt. Key stock indexes, which are market cap based, are near record highs. In the S&P 500, you have mega cap tech Covid winners like Microsoft, Amazon, etc. Are you suggesting that widespread economic weakness will eventually bubble up to drag down these indexes?

Yes. The gap between corporate profits and GDP, or even corporate profits and equity market prices, is wider than it's ever been by a long way. With only a few times in history have we had a gap even approaching these levels of GDP growth, equity market prices, corporate profits, equity market prices and PE ratios. And so, the gains that we've seen have come based on an enthusiasm and optimism placed across the entire market. The actual profits that have been generated and the guidance that has increased are based on a small section of the market. So, I think over 75% of the gains in the S&P 500 in 2020 could be attributed to a handful of names. And so, the breadth of success is extremely narrow. The breadth of risk is extremely wide.

With interest rates so low, what do you make of the TINA argument, which asserts “there is no alternative” to stocks?

I think the phenomena is an anomaly like virtually every pocket of life we're in right now. Money's thrown into the stock market, not just big caps, there's a whole surge of investing that we've seen, maybe with the beginning of the online trading movement, where there are pockets of individual investors who have moved into investing in a way that is creating tons of frothiness. And we've seen, recent examples of how the concentrated energy of small investors can make headlines.

What's your takeaway from GameStop, AMC, Blackberry, etc.?

It means that sentiment and greed can move a market in the face of asking for fundamental justification in the short term. And I think that that is much of what's happened in the macro as well. And this is evidenced by us being at valuation levels we’ve never touched before, even higher than 1929 and 2000-2001

The S&P 500 is trading at about 23 times projected forward earnings. To what extent do multiples deserve to be elevated given ultralow interest rates?

The PE has risen by about 50% from a year ago. The bull case would imply that we're 50% stronger in terms of our earnings premium over our equity premium based on what we pay for earnings. So, common sense would say, what changed in one year for a 50% premium in a market that most people would agree has been propelled with no monetary policy and stimulus?

Fair question. Let’s wrap up with football. How does it factor into your life?

I'm a football player disguised as a portfolio manager. My dream is to buy an NFL team. That’s why our ticker is NFLHX. Our objective is to generate $10 billion for our clients in order for me to buy my football team. And so, my passion and focus in trading is very personal and I’m committed to generating profits for my clients with a motivation that goes far beyond investing. That’s my personal mission.

Do you have your eyes on any team per se?

I would be thrilled to buy the Washington football team because I grew up in Chevy Chase, Maryland.

With the Super Bowl around the corner, who do you want to win and who do you think will win?

I played semi-pro football for 12 years. So, I got to root for Tom Brady because any 40-plus football player is one I admire. My intention when I buy my team is to get on the practice field and hit those guys!

Prove you still have it, right?

Absolutely. My dream was always to play in the NFL and that's going to be my ticket. I'm going to play on my own team and practice.

That’s the very next best thing. 

Absolutely.

I really enjoyed speaking with you and appreciate you taking the time.

Thank you.

Thanks very much, James. 

Greg Bartalos (@gregorianchance) is editor of New York City-based RIA Intel.

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