Investors Don't Understand the Water They're Swimming In Today
Editor's note: As stocks march to record highs, investors are throwing caution to the wind...
They're ignoring all the danger signs. They think stocks will keep rising forever. Of course, that isn't the case... Eventually, this historic bull market will run out of gas.
In today's Masters Series, Extreme Value editor Dan Ferris looks at a set of expectations that many folks have come to accept without questioning in recent years. But as he explains, some of these expectations could be catastrophic for unprepared investors...
Investors Don't Understand the Water They're Swimming In Today
Imagine two young fish swimming along one day...
An old fish comes up to them and says, "Good morning, boys. How's the water?"
The two young fish keep swimming. Then, one turns to the other and asks...
"What the hell is water?"
It might seem crazy that a fish wouldn't even know about the most important life-sustaining aspect of its existence. But fish only know water is important when you lift them out of it.
The same thing can be said for investors.
Imagine you're holding 1,000 shares of social media giant Facebook (FB)...
The stock is trading at about $215 per share. It's up about 40% over the past four months, so you want to take some profits off the table. You enter your sell order into the market.
But instead of cashing out at about $215 per share, your order is filled at $175 per share in the blink of an eye. This might sound absurd, but it's exactly what happened last summer...
Facebook closed at an all-time high of $217.50 per share on July 25. Then, shortly after the closing bell, the company reported its latest quarterly earnings... And it didn't go well.
Executives said they expected revenue growth to continue slowing in the second half of the year. As a result, investors in Facebook tried to sell their shares as quickly as they could.
But here's the thing... The liquidity wasn't there anymore.
In extended trading on July 25, the stock lost about one-fifth of its value. It opened the next morning at less than $175 per share – 19% lower than its closing price the day before. It closed on July 26 at $176.26... And it never traded for more than $180.13 that day.
The quick, steep drop tells us that no one wanted to buy the stock at all the price levels between $217.50 per share (its close on July 25) and the high $170s (where it traded for most of the next day). When liquidity dries up like that, it can destroy your portfolio.
The scary thing is, liquidity isn't the only thing investors are taking for granted today...
They've developed an entire set of expectations that they likely just accept as fact without thinking about it. And some of these expectations could be disastrous if investors aren't ready.
One such expectation is the relationship between stocks and bonds...
The following chart is taken from a report by investment-management firm Grantham, Mayo, Van Otterloo. It shows that stocks and bonds have often correlated positively over more than a century. But for the past couple of decades, bonds have gone up when stocks have gone down. In other words, stocks have negatively correlated with bonds...
As any good mathematician will tell you, correlation isn't a magic, immutable relationship. It can be quite random. It shouldn't be assumed the past correlations will continue indefinitely into the future.
Part of the reason bond yields have fallen is that the Federal Reserve has used interest rate policy to support stock and bond prices. By supporting bond prices, relatively low stock yields become more attractive by comparison. Also, interest rates are key inputs in valuation calculations. The lower rates go, the higher the valuations those calculations spit out.
That brings us to another assumption that investors take for granted today...
They believe the Fed can – and will – save us when the next storm rolls in.
It's an idea we've become accustomed to – that the Fed can make the stock market go up whenever it pleases. We've seen this play out once again over the past several months...
In 2018, the Fed raised the "federal funds rate" – an overnight bank lending rate – four times. And it maintained that it would continue hiking the benchmark interest rate moving forward. Plus, the Fed began unwinding its balance sheet at $50 billion per month.
The Fed's aggressive stance spooked investors, who headed for the exits... The S&P 500 Index plunged nearly 20% in three months – from late September through Christmas Eve.
Then, just like that, the Fed balked on its plan to implement further hikes. As a result, stocks bounced back and rallied to new all-time highs. And now, the Fed appears to have completely reversed course... Futures traders are increasingly pricing in a rate cut in 2019.
But that's not all... Just this week, the Fed announced that it's considering a new program to help reduce its balance sheet. Under this proposed plan, the Fed would encourage banks to use their "excess" reserves to buy U.S. Treasury bonds from the central bank.
Reserves are like cash... A dollar of reserves is always worth a dollar. It can't be marked down. But U.S. Treasurys aren't like cash... They can be marked down.
So if a bank uses its excess reserves to buy Treasurys, and Treasury prices fall... the bank's capital will fall. That would make it harder for banks to lend into our debt-reliant economy.
And most important, it would throw a massive monkey wrench into the stock market.
This move would be equivalent to the Fed's "quantitative easing" program, under which it bought billions of dollars' worth of Treasury bonds every month. The only difference is that now the banks would be doing the buying and the Fed would be doing the selling.
Just what you'd expect... The Fed is considering ways to get banks to take on more risk, something it has done before almost every major crisis over the past century.
Meanwhile, investors have also gotten used to low default rates for risky debt instruments...
Since about 2010, the default rates of risky high-yield – or "junk" – bonds in the U.S. and Europe have mostly been between 1.5% and 4.5%. That's much lower than we'll see in the next storm... During the dot-com bust and financial crisis, default rates exceeded 12%.
And investors aren't getting paid enough for the risk they're taking on with junk bonds...
Junk-bond spreads over U.S. Treasurys have been low since 2010. The spread between the JPMorgan Global Aggregate High Yield Index and comparable Treasurys peaked at around 1,800 basis points (bps) during the financial crisis, meaning junk bonds yielded 18% more than comparable Treasurys.
It was one of the all-time greatest moments to buy them during my lifetime. But that's far from the case today... The index is at about 479 bps. And it dipped below 400 last year.
That isn't the only high-yield market that's flashing danger signs right now...
As my colleague Mike DiBiase wrote recently, the leveraged loan market recently hit $1.6 trillion. That's double this market's amount at the end of 2008.
Leveraged loans are loans that banks make to companies with lots of debt. It's a risky proposition. Yet their default rates are now less than 1%, according to S&P Global Market Intelligence – the lowest level in nearly seven years. That doesn't mean it will end well...
While the default rates are low, the protective covenants in these leveraged loans are the weakest since the financial crisis. As Mike explained in his recent essay, more than 85% of leveraged loans are considered "covenant lite" today, up from just 17% in 2007. With weaker protections for lenders, this will likely lead to reduced recoveries in the event of default.
So the lowest-quality bonds are priced for nothing but the best of times ahead. And the lowest-quality loans are growing increasingly lower in quality and also priced for perfection.
It's a recipe for disaster.
Tomorrow, I'll explain why investors don't have much room for error in the markets right now. And more important, I'll show why it's the ideal time to get ready for the next storm.
Good investing,
Dan Ferris
Editor's note: On Wednesday, May 15, at 8 p.m. Eastern time, investing legend Jim Rogers will sit down with Porter for our Bear Market Survival Event. During this FREE online event, you'll learn why the next bear market will be the worst in our lifetimes... how to know when it's arriving... how to grow your wealth while others are wrestling with disaster... and much more. Click here to learn more and to reserve your spot.