Beware a Bond Market Reversal

Oil soars on OPEC news (again)... Saudi Arabia throws in the towel... Badiali: OPEC still doesn't matter... Interest rates hit new 27-month highs... Beware a bond market reversal... Doc Eifrig: Prepare for the 'Trump Slump'...

This morning, crude oil soared to new 17-month highs...

Today's rally follows news on Saturday that oil cartel OPEC had finalized its agreement with non-OPEC producers to cut global oil production.

According to reports, Russia and 10 other non-OPEC producers will cut their output by 558,000 barrels per day next year, representing the first agreement between these groups in 15 years. In addition, Saudi Arabian energy minister Khalid Al-Falih unexpectedly said his country would cut its production "substantially" more than originally announced. As Bloomberg reported...

"I can tell you with absolute certainty that effective January 1 we're going to cut and cut substantially, to be below the level that we have committed to on November 30," Al-Falih said Saturday in Vienna. The Saudi minister added that the country was ready to take production below 10 million barrels a day, a level it has sustained since March 2015.

Al-Falih and his Russian counterpart Alexander Novak also revealed Saturday that they have been working for nearly a year on the agreement, meeting multiple times in secret. OPEC two weeks ago agreed to reduce its own production by 1.2 million barrels a day, and Saudi Arabia has long insisted that any cuts by the group be accompanied by action from other suppliers.

West Texas Intermediate crude – the U.S. benchmark for prices – rallied more than 4% to nearly $54 per barrel.

This agreement could push prices higher in the near term...

But it's an undeniable sign that Saudi Arabia and OPEC have lost their "game of chicken" with U.S. shale-oil producers...

As we've discussed, the Saudi-led cartel has been flooding the markets with oil for nearly two years now, hoping to push the shale-oil industry out of business and regain market share. This historic deal is a sign OPEC can no longer afford to play this game. As the Wall Street Journal reported...

This agreement represents a capitulation of sorts by the Saudis in their two-year "battle" with U.S. oil producers. On their own, the Saudis may have stayed the course longer. However, they have been pressured by other OPEC members who are having serious fiscal problems (with large portions of the population working for the government). Moreover, the Saudis experienced a serious liquidity problem in the banking system which was among the issues that forced the nation to issue bonds. Many Saudis were quite spooked by the banking situation, especially as the market tanked. It was decided that enough is enough.

Still, as we've explained, this move may be less effective than OPEC believes. As prices move higher above $50, it will become profitable for more and more U.S. oil companies to begin producing again. And the latest data continue to bear this out...

On Friday, oil-services firm Baker Hughes reported the U.S. oil rig count jumped by 21 to 498, the biggest weekly increase since July 2015...

Increasing U.S. production could offset much of OPEC's planned reduction and keep a lid on prices.

Our resident resource guru, Matt Badiali, agrees...

Regular Digest readers know Matt has been following this story since the beginning. In last Friday's edition of our free Growth Stock Wire e-letter, Matt explained why OPEC's latest plan still doesn't "matter"... and why today's high prices are unlikely to last...

We said we'd believe it when we saw it. Well, now we've seen it. On November 30, the Middle-Eastern oil cartel known as the Organization of the Petroleum Exporting Countries (or "OPEC") finally agreed to a modest reduction in its massive oil production. This is critical because oil prices have plummeted since 2014 due to OPEC's unrestrained production...

This time, the OPEC countries agreed to cut 1.2 million barrels per day of production. That would be a 4% reduction, roughly 1% of the global supply. That's a huge amount of oil to remove from the market, and it should be enough to keep oil prices above $50 per barrel for a short time, at least.

Remember, though, there is still a lot of oil out there. And higher prices will bring some of it back on line. If you own any oil producers, make sure to keep your stop losses tight... because that extra supply will likely push oil prices lower again.

Meanwhile, higher oil prices are largely being blamed for the continued rise in interest rates...

This morning, the yield on benchmark 10-year U.S. Treasury notes jumped above 2.5% for the first time in more than two years. Yields have now risen more than 120 basis points since hitting an all-time low of 1.33% in July.

What does oil have to do with it? Some analysts believe this is one more sign that we're approaching higher consumer prices (aka "inflation"). And inflation is terrible for bonds. As the Journal explained...

Higher oil prices raise investors' expectation toward a rise in consumer prices. Inflation chips away bonds' returns over time and is a big threat to long-term government bonds. A gauge of 10-year inflation expectation in the U.S. bond market Monday rose to the highest in more than two years and brushed above the Federal Reserve's 2% inflation target.

"It does seem to be oil-driven, but clearly the bearish sentiment around fixed income prevails," said Mitul Patel, head of interest rates at Henderson Global Investors...

Government bond yields in the developed world have been rising after falling to record lows during the summer, reflecting a big shift from expectation of soft growth and low inflation toward stronger growth and higher inflation. The narrative has been gaining more traction after the U.S. election in early November, driven by the prospect of large fiscal spending, lower taxes, and lighter banking regulation advocated by U.S. President-elect Donald Trump.

We suspect the bond market may be getting ahead of itself...

This summer, we noted that practically everyone – outside of "Bond God" Jeff Gundlach – thought interest rates were a one-way bet lower. And that kind of one-sided sentiment always makes us nervous. As we wrote in the July 13 Digest...

In short, thanks to central bank manipulation, boring bonds have suddenly become exciting speculative vehicles. And U.S. Treasury bonds in particular – which many believe could be the next target of foreign central banks and investors – are more loved than they've been at any time in recent history.

Sure, there are legitimate reasons why this trend should continue... And perhaps the unprecedented central bank easing programs mean the usual indicators are no longer applicable. But we're still skeptical. History shows us there are always logical and convincing reasons why "this time is different"...

For example, in the late '90s, everyone loved Internet stocks. If you were an investor at the time, you may remember there were plenty of reasons these stocks weren't expensive and could only go higher... Back then, they said profits didn't matter in the "new economy." It was all about clicks and "eyeballs."

In the mid-2000s, everyone loved housing, and there were plenty of reasons it wasn't expensive and could only go higher. How many of you remember hearing folks say things like, "They aren't making any more land"?

Today, a similar situation could be playing out in bonds. We see that even folks like us – who think most bonds are too expensive and risky to buy today – generally agree that central bank easing is virtually certain to push yields lower... Who knows... maybe it is different this time. But we wouldn't bet on it.

Of course, as you can see in the following chart, yields have nearly doubled since then...

But now the opposite is true...

Investors have become incredibly bearish on bonds. In fact, as the Journal reported this morning, folks are now betting on higher rates like never before...

Speculators had record net short positions in U.S. Treasurys in the most recent week of data from the Commodity Futures Trading Commission, according to TD Securities.

Ten-year equivalent net shorts increased to -$71.9 billion from -$58.2 billion a week earlier, the most since TD began tracking the data in 2008.

In short, we don't expect interest rates to return to this summer's all-time lows anytime soon... The long bull market in bonds appears to be over, and much higher interest rates are likely in the coming years.

But today's lopsided sentiment suggests another reversal is likely in the short term. Don't be surprised if rates move sharply lower – meaning bonds move sharply higher – from here.

Meanwhile, investors are getting downright giddy about stocks...

We've discussed how several notable investors think Donald Trump's victory could mark a significant turning point for the United States. They believe his policies could usher in a period of strong economic growth and higher inflation for the first time in a decade or more.

We believe it's still too early to say what a Trump presidency will really look like. But here, too, we note signs the "Trump Trade" in stocks is likely overdone...

Major U.S. indexes have set multiple new all-time highs in recent weeks, yet several market indicators are hitting their most "overbought" extremes in years. Meanwhile, the Volatility Index ("VIX") – the market's "fear gauge" – has plummeted back to near all-time lows below 12, while measures of investor sentiment have soared to optimistic extremes.

Again, history suggests at least a near-term reversal in stocks is likely.

But we aren't the only ones who think so...

Longtime readers know our colleague Dr. David "Doc" Eifrig has been among the most bullish Stansberry Research analysts for some time. For years now, Doc has maintained his stance that the U.S. economy was slowly "grinding higher," and the bull market in stocks would continue.

Now that markets have been soaring after last month's election, you might assume Doc is even more bullish. But that's not the case. Doc shared his latest thoughts on the market with his Retirement Trader subscribers on Friday...

Overall we expect the markets will likely be up over the next year or so. But today, we're getting a little more cautious. The "Trump Trade" looks like it's about to roll over.

Like us, Doc says the recent rally has been based on expectations, not reality...

We don't really know what Trump's infrastructure plans are. We don't know what his regulatory plans are. He's made a lot of promises. But until he's inaugurated and starts crafting an actual legislative agenda... it's just talk. We don't know much at all.

Look at biotechnology: Hillary Clinton promised price controls on expensive drugs, so when Trump won, biotech shares surged. The thinking went that the pro-business, free-market candidate would allow drug makers to collect better profits.

Unless he won't. This week, Trump told Time magazine, "I'm going to bring down drug prices. I don't like what has happened with drug prices." Those same biotechs started giving back their gains...

As Doc noted, this doesn't mean the market is wrong about Trump. We simply don't know... And it's this uncertainty that concerns him...

He's just as likely to leave drug-pricing rules alone as he is to reform them... regardless of his most recent statement. It just means that any big moves based on Trump can swing the other way thanks to a late-night Tweet or an off-the-cuff remark.

The market's going to get wise to this uncertainty soon. It'll likely cool off for a bit.

To be clear, Doc isn't getting bearish today... But like us, he believes the "Trump Trade" is likely overdone, and he's betting a reversal is likely.

New 52-week highs (as of 12/9/16): Automatic Data Processing (ADP), American Financial (AFG), Altius Minerals (ALS.TO), Axis Capital (AXS), Boeing (BA), Bank of Montreal (BMO), Berkshire Hathaway (BRK-B), CME Group (CME), Corsa Coal (CSO.V), WisdomTree SmallCap Dividend Fund (DES), ProShares Ultra Oil & Gas Fund (DIG), iShares Select Dividend Fund (DVY), WisdomTree Japan Hedged SmallCap Equity Fund (DXJS), EOG Resources (EOG), BlackRock Floating Rate Income Strategies Fund (FRA), iShares Core S&P Small-Cap Fund (IJR), PureFunds ISE Mobile Payments Fund (IPAY), Nuveen Floating Rate Income Opportunity Fund (JRO), Microsoft (MSFT), Newfield Exploration (NFX), PowerShares High Yield Equity Dividend Achievers Fund (PEY), PNC Financial Warrants (PNC-WT), Potash Corporation of Saskatchewan (POT), VanEck Vectors Russia Fund (RSX), Spirit Airlines (SAVE), Sysco (SYY), and W.R. Berkley (WRB).

Several readers respond to Porter's Friday Digest. What did you think? Let us know at feedback@stansberryresearch.com.

"Porter, this is what you wrote about being the best. I have a great question, 'Why would you want to be anything less than the best?' As a person. As a business owner. As anything in life. One of the reasons I read Stansberry products is that they are the best. Whether it is right or wrong doesn't matter. In my heart I know that the best is always done. To me that is what matters. I don't settle for second best. How do I know? Simple. I see it in my kids. They have seen this in me and my wife and have grown up to be very high quality women. Thanks for all that you produce and to all that produce it." – Paid-up subscriber Jeff S.

"Enjoyed your OneBlade story and appreciate your effort... I had the privilege of working for an aerospace company that exemplifies your Niobium theme. Shortly after I joined the organization in 1973 as a young marketing guy, I was successful in securing a large subcontract from Dr. John Bull's Space Research Corporation. But during my visit to their facility outside Burlington, VT I was given a tour. When I asked the tour conductor about the bright orange stripe running down the center of their manufacturing floor, he said it was the international border with Canada. His reply to 'doesn't that make it difficult to control production' was 'No, comes in handy sometimes' with a smirk.

"So when I returned to my company, I told my President 'the good news is we won the big contract, the bad news is we should NOT accept it'... and told him of the tour. He agreed, we sent a registered letter withdrawing our bid. Six months later the scandal broke with SRC caught shipping the product we would have been involved in to South Africa. As a small company, the scandal would have been a disaster likely resulting in cancellation of most of our DoD programs. This was only one of many examples of doing the right thing, even if it cost short-term financial pain." – Paid-up subscriber J.C.

Porter comment: Character is doing what's right, even when no one is looking.

"Hi Porter, I want to thank you for creating OneBlade. I purchased one when it launched and have been very happy with it. At first I wasn't confident to use it around my upper lip and around my mouth – you can hear and feel the extreme sharpness of the blade and I wasn't sure I could shave in those places without a cut. But within a couple of weeks I was using OneBlade for my entire shave, and with confidence. I have not cut myself with OneBlade once.

"A couple of other notes: I appreciate precision and engineering as you do, the reference in the Digest to BMW and Rolex is spot on. Personally I vowed many years ago only to purchase an automobile manufactured by a company that participates in Formula One racing. Why? Because they are dedicated to being the best and to constant innovation. I also own a Rolex (and a IWC and a Glaschutte) for the same reasons. Not bragging, I just want get the best and I believe the best can only sprout from passion.

"Lastly, in your original marketing for OneBlade there was a point about shaving with OneBlade being a 'ritual'. I thought it was just good copywriting. But you know what? It is now a ritual for me – no screens, no noise, a time for quiet contemplation and a time to literally look myself in the mirror and to consider things that are important to me and my family. You have done men around the world a great device Porter, and I thank you." – Paid-up subscriber Darin Williams

Regards,

Justin Brill
Baltimore, Maryland
December 12, 2016