Porter's latest prediction is coming true...
Porter's latest prediction is coming true... The next 'subprime' disaster is approaching... Reader feedback: Insurance stocks versus bonds...
Porter has made some incredible predictions over the years...
Longtime Stansberry Research readers remember he warned again and again that "blue chip" automaker General Motors was bankrupt, years before it was front-page news.
He unequivocally told subscribers in June 2008 that Fannie Mae and Freddie Mac were "going to zero" – at the same time former U.S. Treasury Secretary Hank Paulson was testifying to Congress that the companies were "well capitalized" – just weeks before both collapsed.
Likewise, he predicted the shale oil and gas boom here in the U.S... and the resulting crash that would send oil prices to less than $40 a barrel again.
As you likely know, Porter made another big prediction this summer, just a few days before the U.S. stock market plunged more than 10% in late August. As he summarized in a recent Friday Digest, he believes we're about to see "a period of vast credit default"...
I'm afraid if I keep writing about the issues that concern me right now, you are all going to quit reading the Friday Digest... But I can't help myself...
If you're prepared, the next 12-36 months will be a great investment period for you – one of the three or four best opportunities in the last 50 years. If you're not prepared, you'll likely get wiped out. So I feel obligated to try, again, to show you what I see in the markets right now.
We are approaching a period of vast credit default... Credit-market troubles are different than equity-market troubles. Credit-market troubles are "contagious" and are amplified by leverage. Companies funded with equity go bankrupt and nobody notices. But when companies (or countries) funded with huge amounts of debt go bankrupt, it triggers a chain reaction. Institutions that would otherwise be sound can end up in default because they've invested in toxic debt. That's what's about to happen all around the world.
Far, far, far too much money – mind-boggling amounts – has been borrowed by people and countries that are not creditworthy. These debts are going bad. The chain reaction is starting. And nobody knows exactly what will happen next because the world has never seen so much bad debt before.
This will be the greatest legal transfer of wealth in history.
In particular, Porter singled out three areas where credit bubbles have grown the largest and where "contagion" is most likely to begin:
| • | The U.S. oil and gas industry, where non-creditworthy companies borrowed hundreds of billions of dollars through the high-yield corporate – or "junk" – bond market... |
| • | The auto industry, where the latest boom was financed with nearly $900 billion in auto loans, much of it low-quality or "subprime" credit... |
| • | And higher education, where students have racked up an incredible $1 trillion-plus in student loans. |
In the October issue of Stansberry's Investment Advisory, Porter and his team reviewed why these three markets, in particular, have gone awry...
The important thing to understand is how cheap financing and tremendous amounts of money printing by the Federal Reserve and other central banks around the world have created an enormous bubble in the credit markets.
For starters, cheap money flowed into the oil and gas patch. Companies overextended their balance sheets thinking that oil would trade at $100 or more forever. With oil now trading for less than half that, they find themselves overleveraged... struggling to make enough money to service the debt...
A second bubble created by the Fed is in subprime auto loans. Far too many people are buying cars they can't afford. Again, cheap money has allowed financial institutions like General Motors (GM) – through its GM Finance arm – and Santander Consumer USA (SC) to facilitate loans to poor car buyers. To help finance further loans, these companies package the loans on the books and sell them to investors.
As he explained, the exact same thing happened with the subprime-housing market in the early 2000s...
The third looming default crisis building in the U.S is student loans... Americans today owe roughly $1.3 trillion (and counting) in student loans. That's up from less than $200 billion in 2000 – a 550% surge in 15 years.
As usual, this expansion had nothing to do with real supply and demand or the creation of value, but was simply an outgrowth of the government's good intentions and fiscal recklessness.
Of course, regular readers know his prediction is already starting to come true...
As we discussed earlier this month, 23 energy companies have defaulted on their debt so far this year, according to ratings agency Moody's. We expect many more are coming.
We've been watching the problems in these companies play out in real-time through the chart of the iShares iBoxx High Yield Corporate Bond Fund (HYG) we've been following in the Digest...
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As bad as these problems are, Porter believes the problems in auto and student loans will be even worse...
In Friday's Digest, he shared new data that show just how bad the situation in the auto-loan market has become...
The amount of super-low-quality auto lending is now surpassing the totals of dubious lending that peaked in 2006. Total auto lending in the U.S. is now more than $1 trillion – the all-time highest amount of debt tied to cars in the U.S.
Newsletter publishers like to say the "sky is falling" all the time about every small problem we face. But this isn't a small problem. The comptroller of U.S. currency is issuing a warning to anyone who will listen. He says this situation with auto loans reminds him "of what happened in mortgage-backed securities in the run-up to the crisis" of 2008...
Today, subprime lending makes up nearly 40% of all auto loans. These loans will go bad. When they do, the industry will be completely devastated – every bit as bad as when the mortgage bubble popped. The size of the auto-lending business (more than $1 trillion in loans) means that when this happens (and it certainly will happen), the resulting damage will hurt the entire financial sector and our economy.
Now, we have the first signs of serious trouble in the student-loan market as well...
Believe it or not, a big chunk of "AAA" investment-grade debt could soon be slashed to "junk" status. Be sure to read tomorrow's Digest for the details.
New 52-week highs (as of 11/20/15): American Financial (AFG), Aflac (AFL), Activision Blizzard (ATVI), Chubb (CB), Lancashire Holdings (LRE.L), McDonald's (MCD), Sinclair Broadcast (SBGI), Travelers (TRV), and Valero Energy (VLO).
Porter takes the time to answer a reader's bond question in today's mailbag. Send your questions to feedback@stansberryresearch.com. But remember, we can't offer any individual investment advice.
"Hi, Porter: I have 2 questions: 1) You always talk up how one should be invested in INSURANCE companies (at least those listed in Stansberry's Investment Advisory). How do they stack up against bonds? Bonds still a better investment? 2) The other analysts ALWAYS listed bonds with a lower overall portfolio allocation than stocks when listing diversification strategies. If bonds are so wonderful, why the back seat to stocks?? Thanks." – Paid-up subscriber Marty Gerrity
Porter comment: Good questions, Marty.
In many ways, an investment in an insurance company is an investment in bonds, as most high-quality insurance companies (W.R. Berkley, for example) only own bonds in their investment portfolios. But digging deeper into the meaning of your question... there's plenty of proof that over time, stocks are vastly superior investments than bonds.
Think about it... The lion's share of profits ends up in the hands of the shareholders. So if your goal as an investor is to maximize total returns, there's no question you would greatly favor stocks over bonds – perhaps exclusively. And if you've noticed, Stansberry Research features far more content about stocks than bonds or any other asset class.
But – and this is a big but – what I have said is that for most actual individual investors, they would be better off only buying corporate bonds. There is a hole the size of the Grand Canyon between what investors should be capable of earning in stocks and what they actually earn, according to several studies of individual investors' actual returns.
As you surely know, there are plenty of investors who bought at the top around 1999 or 2000 and sold at the bottom in late 2008. As I've explained, lots of folks start out as "buy and hold" investors but end up as "buy and fold" investors. These people tend to drag down the averages. For these folks, bonds are a clearly superior option. So if you've had trouble making money in stocks or if you know that you can't tolerate the volatility of stocks, consider buying corporate bonds.
I've also said that during periods of stress in the credit markets, you can frequently find discounted corporate bonds that offer investors better returns than you can find in stocks (capital gains between 50% and 100%, plus huge amounts of annual income) with far less risk. If you define risk as the permanent loss of capital, there's no question that corporate bonds provide investors with much less downside – on average – than stocks. Historically, recovery rates on both investment-grade debt and noninvestment-grade debt have been more than $0.40 on the dollar.
Here's an example of what that means in the real world. In the first issue of Stansberry's Credit Opportunities, we recommended buying a bond for $0.70 on the dollar – that's $700 to purchase a face-value $1,000 corporate bond. The company is in the energy sector and its share price has been blown out, down 90% or so. If you buy the stock, there's a real chance it could go to zero.
But we don't think that's going to happen. As subscribers know, we have good reasons: The company's revenue stream is diversified (energy isn't its only game) and, more important, this company is extremely capital efficient. Understanding the business from the standpoint of equity analysts gives us a big advantage in the bond market because credit rating doesn't typically take the business model into account.
Let me be clear... we don't think these bonds will default. When they mature in 2018, we expect they will pay investors $1,000. Likewise, we expect the coupon payments will be made in full and on time. If that occurs, investors will earn 24% a year (a total return of 82%). In my book, that's better than you can realistically hope to make in stocks, as most investors don't earn anything close to 24% a year in stocks.
What's the downside? Assuming the worst comes to pass, we predict a recovery of $0.25 on the dollar for these bonds. If you buy them at $0.70 and you end up getting no coupon payments (virtually impossible, since the company has plenty of cash), you would lose 64% of your investment.
That's a lot, but it isn't as much risk as buying the company's stock. And that's technically the most we believe you could lose. Subscribers have seen how conservative we are in our liquidation analysis... We give the company zero credit for more than $100 million in current assets. And we're only counting 20% of its most valuable productive assets, whose fair value today is more than $1 billion. It pays to be conservative, though, because bankruptcy usually takes longer and costs more than anyone expects. It's a wise policy to take your actual estimate of recovery value and cut it in half.
Reality is also different than a spreadsheet. Selling assets or additional equity and using the proceeds to buy back its debt is one thing a company can do – and often does – to alleviate credit distress. When the debt is distressed, this is akin to repaying debt for pennies on the dollar. Imagine if you could repay your mortgage on the same basis. That's why when you buy distressed debt, you have to be willing to hold it – almost no matter what. Thus, the best way to protect against the risk of an actual default is to be diversified. (Where have you heard that before?)
With distressed debt, one of the best ways to minimize risk is to figure out how many coupon payments you will definitely receive. The bond I just mentioned pays a 9% coupon. Assuming it doesn't default, by the end of year two, we will have already gotten more than 25% of our initial capital back. If you combine this with the actual average of recovery amounts ($0.40 on the dollar), that implies we're really only risking about 11% of our capital, since we're buying at a large discount to par. That's probably a bit too optimistic, while the prospect of losing 64% is probably too pessimistic. And remember, that's the worst-case outcome. We believe these bonds will be "money good."
One more thing... What if we're at (or near) a bottom in energy prices? That's not my base case, but what if bombs start going off all over Saudi Arabia tomorrow? It could easily happen. If energy spiked higher, you could probably sell these bonds immediately at prices at or above par. So your returns here could be much larger than we expect (on an annualized basis).
That presents us with a risk that few investors consider: What if the outcome in this sector is much better than people currently expect? If this stock suddenly moved higher, then the real risk we face as bondholders isn't default, it's the opportunity cost of not being a shareholder. As recently as the last three years, this stock traded at more than $40 per share. It's now trading at less than $2 a share. A return to anything close to its former highs would make you 25 times your money. The downside, of course, is that you're risking 100% of your capital if you buy the stock.
Fortunately, there is a way to bridge this gap. Some bonds offer a "convertible" feature. This gives you the option of being paid back in $1,000 of stock instead of cash. A normal convertible feature pays you out based on a predetermined share price. In an example like this, where the stock is down so much, the convert price might be $15 or $20 per share. When the convert is that far "out of the money," it typically doesn't play a role in the bond's pricing at all. This means there's a completely free "call option" embedded in the bond. You can get the right to convert into stock for free.
You will see us recommend a lot of these convertible bonds. That's how our former bond analyst, Mike Williams, earned more than 700% for investors in the legendary Rite Aid 5.5% bonds he recommended at the peak of the last crisis in February 2009.
But even when there isn't a convertible feature, there's an easy way to build a convert into the bonds you buy. We showed subscribers exactly how to do this with the first bond we recommended. In this case, adding in this equity feature puts us in a position to make roughly 10 times our money if the stock price rebounds to just half its former high price. Think about the risk-to-reward setup that creates. The worst-case downside is probably 50%. The reasonable upside potential is 10 times our initial capital. Try finding those opportunities in the stock market alone.
Regards,
Justin Brill
Baltimore, Maryland
November 23, 2015
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