The Dreaded 'S' Word Returns

The Trump 'ripples' continue... Rate-hike odds approach 100%... The market is preparing for inflation... But don't count on growth... The dreaded 'S' word returns... 'You can either be a winner or a victim... It's up to you'...

---

It's been nearly two weeks now since Donald Trump's election-night victory...

But the market ripples continue to spread...

First, we note the odds of a Federal Reserve rate hike next month have soared. According to the CME Group's FedWatch tool, the probability of a December rate increase has jumped from 68% prior to the election to more than 90% today. Bloomberg reports the market is now also pricing in additional rate hikes down the road...

Beyond December, swaps trading shows the expectation for a faster tightening cycle. Overnight index swap contracts implied the central bank's benchmark rate will be 1.25% in two years' time, compared with an expected 0.83% on Nov. 7, the day before the U.S. election. That means the market is pricing in another hike as Trump's win and a Republican-controlled Congress portend a wave of spending to bolster the U.S. economy.

Why? It appears the market believes Trump's infrastructure and trade proposals could create significant price inflation for the first time in years... which in turn could boost the economy. As Mark Nash, the head of global bonds at Old Mutual Global Investors, put it in an interview with Bloomberg last week...

It's hard not to think this is incredibly reflationary for the global economy... We believe there should be more hikes priced in and bond yields should rise.

And he's clearly not alone...

Bank of America Merrill Lynch's ("BAML") latest fund-manager survey released on Wednesday showed a net 35% of managers expect the global economy to improve over the next year. That may not sound impressive, but it's the highest level in at least 12 months... and nearly double last month's 19% result.

Likewise, 29% now expect corporate profits to improve over the next 12 months. This is the highest number in 15 months, and nearly three times higher than October's 10% level.

And perhaps most notable, average fund cash holdings plunged to 5% this month, down from 5.8% in October. Managers haven't put this much cash to work in a single month since August 2009... near the end of the last financial crisis.

In short, according to BAML officials, fund managers see the Trump win as "unambiguously positive" for economic growth and in the stock market.

Of course, regular readers know we're skeptical...

As Porter has explained, folks who believe Trump's proposals will save us are likely to be severely disappointed. As Porter wrote in the November 9 Digest...

Some people are happy. Some people are acting like someone shot their dog. But nobody likes my answer about what Trump means for the markets. So what do I believe will happen now? Well, my answer flies in the face of virtually every modern economist and pundit on CNBC. Virtually everyone believes that government spending and/or tax cuts will have a powerfully positive effect on our economy.

The Republicans believe tax cuts and military spending are the basic formula for economic prosperity. The people cheering today believe that Trump's wall (his announced infrastructure spending), his tax cuts, and his estimated $6 trillion budget deficit over four years will create winners in the stock market and wealth for our nation.

In some limited ways, that will prove to be true. The Pentagon, for example, is the world's largest consumer. It buys more oil than any other entity. And if Trump builds a wall across our southern border, he's going to buy a lot of steel. But in other, far more important ways, the idea that government spending and government debt is a positive force in the economy is completely wrong. Fatally wrong.

Again, this is because of an economic principle known as the "declining marginal utility of debt." In simple terms, this is the idea that increasing amounts of debt create smaller and smaller increases in growth. As Porter showed, this is clearly the case for the U.S. economy...

Look at the following chart. We've taken actual U.S. GDP (the total production of our economy each year) and divided it by total public debt. In the 1960s (at the very top of the chart), each additional dollar in government debt produced at least an additional dollar in GDP growth because government spending was a smaller part of the economy and government debts remained small.

Of course, as spending and debts grew, we began to see the effect that the marginal utility of deficit spending started to have. Compared with debt, GDP began to shrink as each dollar of additional debt led to less and less growth in GDP...

Worse, research shows when debts become large enough – more than about 70% of GDP – additional borrowing can actually cause growth to turn negative. And this "negative multiplier" increases exponentially the larger the debts grow.

Today, U.S. debt to GDP sits at more than 100%. As Porter explained, this suggest Trump's massive spending and tax-cut proposals could have the exact opposite effect many expect (emphasis added)...

When you put these ideas together – the declining marginal utility of additional government debt, the negative multiplier of government spending, and the non-linear impact of massive government debt burdens – it's hard to believe that the president can do anything to alter the course of our ongoing credit-default cycle.

The only prediction that's consistent with sound economy theory is that the government is going to make this default cycle a lot worse.

In other words, while price inflation may very well move higher from here, don't count on a return to strong economic growth at the same time.

The return of the dreaded 'S' word?

If you know your history, this situation may sound familiar...

A combination of rising prices and stagnant economic growth – dubbed "stagflation" – was a hallmark of the 1970s.

After nearly a decade of deflation worries following the last financial crisis, few believe this is likely to happen again today. But it could be precisely what Trump's proposals create. As Art Cashin, the well-known director of floor operations at UBS noted to financial news network CNBC last week...

Some people are projecting the idea of the worst of all worlds, stagflation, that you begin to get the inflation they were looking for but the stimulus doesn't really work because of the high level of indebtedness that we have.

It's a little too early to say, but there's an outside chance that it might be our old friends the bond vigilantes who are back, saying, 'OK, you're going to do tax cuts and you're going to do stimulus spending, what is that going to do to the deficit and where are we going to go from there?'

Worse, history shows stagflation is terrible for stocks and bonds alike. As Macquarie strategist Viktor Shvets explained in a recent note (emphasis added)...

The classic stagflationary episode occurred between 1967/68 and the early 1980s. The U.S. economy had effectively moved into stagflation around five years before global oil prices were raised in 1973. It was a period of persistently high and volatile inflation, high unemployment, and volatile industrial production. It was also a period of severe decline in real equity values, with peak-to-trough real fall of ~60%. It was also an exceptionally difficult period for bonds.

The bottom line is simple...

Despite the market's cheers, nothing in Trump's proposals is likely to derail the coming credit-default cycle and the massive bear market to follow. In fact, they're only likely to make them worse.

But you don't have to be a victim. You can protect your savings... and set yourself up to make windfall profits as this crisis unfolds. And it isn't complicated. As Porter explained in the November 11 Digest...

A lot of investors sit in the market, and they're terrified about what might happen next. They can't afford not to be invested. They need income. They need growth. They can't afford to miss what remains of this bull market. Most of these people don't think they can do anything about the risk of big drawdowns or even outright losses, like they suffered in 2002 and 2008. But that's just not the case...

You don't have to be a victim of the market. You really don't. And you don't have to do anything radical like sell all of your stocks, or short the entire market. But you do have to do something.

We created our new Stansberry's Big Trade service to take all the guesswork out of protecting your portfolio and profiting from the coming crisis. Click here to learn more now.

New 52-week highs (as of 11/18/16): American Financial (AFG), WisdomTree SmallCap Dividend Fund (DES), Freddie Mac (FMCC), iShares Core S&P Small-Cap Fund (IJR), Nuveen Floating Rate Income Opportunity Fund (JRO), PNC Financial Warrants (PNC-WT), Gibraltar Industries (ROCK), and W.R. Berkley (WRB).

In today's mailbag, Porter answers a question about "The Dirty Thirty"... and responds to a reader's criticism of his short-sale recommendations. Send your questions, comments, and concerns to feedback@stansberryresearch.com.

"Porter, is there a reason that LNG is not on the dirty 30 list? Seems like an obvious match, according to your post with Bonner [on Sunday]. And more generally, now that there are Jan 2019 options available for many of the targets, what is the tradeoff between the Jan 2018 and the later options? The later ones are more expensive and the available volume often much less, but they give us 2 years for the default cycle to start accelerating (and the pressures on any given stock to build). If we buy carefully and over time, it should still be possible to establish a meaningful position in the longer-dated options, with presumably less risk of expiring with no gain than the shorter-dated options. I would welcome your opinion of these trade-offs.

"I know you can't comment on specific trades, but I am tentatively planning on buying a half position in the Jan 2018 options (have already done so), and the other half position early next year in the longer dated options – spreading my bets, so to speak. Finally, let me thank you again for enabling this opportunity. My retirement account (which allows naked option trades) is not quite large enough to support me and my wife, so the Big Trade is the perfect strategy to boost it to the desired level while risking only 10% of my capital." – Paid-up subscriber Al Hammond

Porter comment: Al, when I recorded the interview with Bill Bonner, Cheniere (LNG) was indeed part of the list. As we refined our work, digging into the individual names, we found that LNG didn't have enough near-term debt maturities to trigger the kind of "run on the bank" that we're expecting.

So we recently replaced it with a similarly indebted business that did have more near-term maturities. The Dirty Thirty is a concept, not a static list. As conditions change, we'll be adding to and subtracting from the list.

"Thank you again for your thoughts and teaching lessons. If valuation would be an easy thing to you, stock markets would not work anymore. In at least three companies you have been quite wrong. 1) First solar, 2) Tesla (so far), 3) salesforce (deadly wrong or do you think that the guys at Microsoft are unable to value a company?) Or do you think they just don't get your points? Where in these cases were you wrong?" – Paid-up subscriber Juerg Kohler

Porter comment: Fascinating note, Juerg. As I read your thoughts, you seemed to be saying that valuation isn't easy because the markets are made up of lots of different opinions about what constitutes a good value. And you seemed to be pointing to three stocks that we said were overvalued and recommended shorting.

First, while I believe valuing equity is easy to do (and to learn), understanding intrinsic value is difficult. What's the difference? Valuing an equity simply means measuring the price of a stock against its earnings, sales, and book value on a per-share basis. Knowing its intrinsic value, however, means knowing if it's worth the price it's currently trading for... or more.

High rates of growth in particular make accurately estimating intrinsic value virtually impossible. And of course, knowing how intrinsic value will change is impossible. Like Yogi Berra warned us, "Predictions are tough, especially about the future."

Nevertheless, I think our main disagreement lies in your evaluation of the usefulness of our analysis.

Take First Solar (FSLR). You said we were "quite wrong" about the company.

For readers who are new to our group, we first recommended shorting First Solar back in January 2008. We did so, at least in part, because we could not imagine any reasonable or logical explanation for the price of its stock.

Its shares were trading for $225 each, which, at the time, meant the company's market capitalization (the value of all its shares) was more than $18 billion... for a company that was selling a low-margin commodity product mainly to governments that couldn't afford it (as Germany and Spain subsequently found out).

But just to be clear, we didn't recommend shorting First Solar solely because the stock was expensive. As we always remind subscribers, we never short on valuation alone. Overpriced stocks can always go higher. We only short companies we feel 1) are going bankrupt, thanks to an unsustainable debt load, 2) rely on an obsolete product, or 3) engage in fraudulent activities.

With First Solar, we pointed to the guarantee liabilities it faced. The company was promising its products would achieve certain benchmarks over a 10-year period. But nobody knew how these products would perform. (And as it turns out, refunds caused big problems at First Solar.)

Likewise, we suspected that the folks who were excited about solar power in 2008 were bound to be disappointed. We knew that solar was extremely expensive and that countries like Germany and Spain, which were investing heavily in solar power, were bound to be disappointed as their economic competitiveness declined due to rising power-generation costs.

And finally... We knew that the margins the company was earning wouldn't last. As we wrote...

Solar power will be a very competitive business. It won't be easy for First Solar to grow its revenues this fast for long. The realities of manufacturing will manifest themselves. Growth will slow; margins will shrink.

Since then, First Solar's operating margins have fallen (now below 15%) and its return on assets is currently a paltry 4%. It's not a company worth getting excited about.

Additionally, we note with satisfaction that First Solar didn't repeal the laws of physics or economics. Virtually everything we warned would happen has happened. As a result, the company now trades at a fraction of its former value. Its market capitalization is $3 billion, but much of that is held in cash. A more accurate way to measure the value of the business is what it would cost to acquire it – $2 billion. Measured this way, the company's value has fallen about 89% since we wrote about it in January 2008.

Between 2008 and 2011, we recommended shorting First Solar three times. Subscribers made money each time, with returns of 1%, 23%, and 26%.

No matter how you choose to measure it... no evaluation would lead you to conclude we were "quite wrong" about the company.

In regard to Tesla (TSLA), we've certainly been surprised by its founder's incredible ability to manipulate both the government and the media into supporting his stock's absurd valuation. Never mind that Tesla misses every manufacturing deadline. Never mind that Tesla is losing hundreds of millions every quarter. Never mind that a large percentage of Tesla's revenue comes from nonsense government subsidies. Somehow, like a Jedi knight, Elon Musk can just wave his hand and the media ignores these facts and reports on Tesla's new battery pack (which no one has bought)... or its new roof tiles (which no one has bought).

Sooner or later, that "magic" won't work anymore.

Who knows how much longer Musk can keep the charade going? I don't know. But my guess is that Trump won't buy a Tesla... and that the government's outsized role in his businesses will decline.

Regardless, as you may know, we've recommended shorting the company's stock three times: in June 2014 (at $206), April 2015 (at $191), and June 2016 (at $218).

In terms of being "right" about the business, the company's current price ($185) is below all of our recommended short entry prices.

We also believe the company's growing financial desperation is pretty good evidence that so far, we've been more right than wrong about the direction the company is headed.

Finally, our most recent recommendation – where we recommended shorting Tesla and solar-panel maker Solar City (SCTY) – is showing an 11% gain in less than six months.

I don't understand how any reasonable evaluation of our work on Tesla could conclude that we were "quite wrong."

On the other hand... in regard to Salesforce (CRM)... here I have to admit you're right. We were dead wrong.

What happened? Unbelievable amounts of growth, far more than we believed was likely.

Cash from operations at Salesforce have doubled since 2014. That kind of growth can easily solve the accounting issues we raised in our write-up.

And so... as you may have noticed, unlike First Solar (which we shorted three times) and unlike Tesla (which we've shorted three times), we haven't criticized Salesforce again.

In fact, we now use its software to help run our business.

What can I say? Nobody bats a thousand.

Regards,

Justin Brill
Baltimore, Maryland
November 21, 2016