Three Warning Signs of the Next Great Depression

The most important Digest I'll write this year... The world's greatest logistics challenge... The Great Engineer's memoirs... Three warning signs of the next Great Depression... Cash and fractional gold eagles... Why you want to own these two gold stocks...

A century ago, one man saved an entire European nation from dying by starvation...

He was heralded as the "Great Engineer" for solving the most consequential logistics challenge the world had ever known...

Securing enough food to feed nine million people every day for four years... raising $12 million each month to pay for it (that's over $300 million in 2019 dollars)...

Navigating a British naval blockade and German occupation to safely deliver the food to those who needed it... Building the necessary nationwide infrastructure to distribute it...

And, most importantly, keeping it out of enemy hands and stomachs during World War I.

Future U.S. President Herbert C. Hoover, then a private citizen, was that "Great Engineer."

He is revered to this day in the country he's credited with saving: Belgium.

But I (Mike Barrett) am not writing this Digest today to talk about Hoover's great humanitarian feats. I want to talk about what he's most known for... presiding over the U.S. during the Great Depression... and, most importantly, the warning signs I see flashing that say history is ready to repeat itself.

American history hasn't been as kind to the 'Great Engineer'...

On "Black Tuesday" October 29, 1929, eight months after Hoover took office as the 31st president of the United States – and almost 10 years after he orchestrated the Belgian relief effort, the stock market crashed.

What many at the time assumed was just an ordinary recession gradually evolved into the Great Depression... a decade-long era of staggering unemployment and financial loss.

Hoover, as sitting president, took most of the blame. Citizens living in sudden shantytowns were so angry they called them "Hoovervilles."

The world's greatest humanitarian had met his match. Nothing he did as president stopped the epic financial destruction.

Hoover left office four years later the same way he entered it – in a landslide... After securing 444 of a possible 531 electoral votes in 1928, he captured just 59 electoral votes during FDR's sweeping 1932 presidential victory.

Fortunately, for those who want to learn from the past, Hoover wrote his own history of the Great Depression...

In the years following his presidency, Hoover wrote a volume of memoirs titled The Great Depression 1929-1941.

The document totals almost 500 pages (you can read the full version here), and it begins by contending that the depression did not start in the United States. Hoover wrote...

In the large sense the primary cause of the Great Depression was the war of 1914-1918. Without the war there would have been no depression of such dimensions. There might have been a normal cyclical recession; but, with the usual timing, even that readjustment probably would not have taken place at that particular period, nor would it have been a "Great Depression."

More than 3,000 books about the Great Depression are available on Amazon.

Hoover's memoirs, available for free, are particularly interesting and valuable, though not for the reason you'd expect from someone who presided over our greatest financial calamity...

American history buffs know Hoover was an exceptional businessman.

After graduating from Stanford University in 1895 with a geology degree, Hoover spent the next two decades in the international mining industry, doing deals, arranging financing, and managing mining corporations.

He was a self-made millionaire. He was also a director for 18 different mining and financial companies that employed some 100,000 people by the time World War I erupted.

That's when he reportedly told a friend, "Just making money isn't enough," and went about his effort for Belgium.

Following the Great War, Hoover became the third U.S. Secretary of Commerce, serving from 1921 until his presidential inauguration eight years later. During his time on the job, Hoover played an important role promoting the emerging broadcast radio and airline industries.

In short, this was a man who knew the business world of the 1920s – the period preceding the Great Depression – very well.

Remember, the Great Depression didn't happen overnight...

It was the culmination of a decade's worth of speculative excess. Because of his deep business experience, Hoover was well aware of the risks building in the global economy and repeatedly warned of them.

In a press statement on New Year's Day 1926, Hoover presciently wrote...

Psychology plays a large part in business movements, and overoptimism can only land us on the shores of overdepression.

Three years later, in late 1929, the stock market was at new all-time highs and had been climbing relentlessly for almost a decade. The colossal destruction lying ahead was unimaginable.

Thanks to the Great Engineer's exhaustive postmortem, we have a firsthand account of the forces that conspired to wipe out a decade's worth of stock gains, and plunge millions of Americans into poverty and despair.

The U.S. banking system was clearly the weakest link. But there were other serious problems as well, which Hoover details in his memoirs.

Why am I bringing this to your attention today, some 90 years later?

Because there are ominous parallels to what I'm seeing in the global and American economies today...

The analysis you're about to read is why I consider this the most important Digest I'll probably write this year.

History is providing an important lesson, and your future financial well-being just might depend on if you're willing to consider it and how well you grasp the situation.

As was true of the 1920s, stocks have mostly been a one-way trip to higher prices and strong returns over the past decade. They're once again at or near all-time highs, this time spurred by "phase one" of a U.S.-China trade deal.

Meanwhile, the forces Hoover identified as exacerbating the downturn into the Great Depression are once again present today.

I consider these three warnings the Great Engineer's gift to today's investor...

No. 1: Don't underestimate the potential for economic "contagion," or for the problems of economies to spread like a contagious disease.

No. 2: Years of commodity overproduction turns disastrous when economic crisis erupts.

No. 3: "New Economic Era" sentiment breeds dangerous complacency.

Let's take a much closer look at each of them...

Warning No. 1: Don't underestimate the potential for economic contagion...

Hoover asserts that the center of the economic storm began in Europe and had already spread to "economically sensitive" parts of the world when the U.S. stock market crashed in late 1929.

Many historians disagree, concluding the storm started here and quickly spread elsewhere.

Where the economic crisis originated is irrelevant. What's important is that once the match was lit, it quickly turned into an international inferno because economic conditions were weak everywhere.

The global economy is once again weak today.

Three months ago, I discussed one of my favorite U.S. economic indicators – the Chicago Fed National Activity Index ("CFNAI"), noting it has been signaling waning economic activity over the past year.

The CFNAI is designed to give a comprehensive snapshot of U.S. economic activity.

It relies on 85 different growth indicators – including plant utilization, hours worked, home sales, and inventory levels. Its statistically derived trigger points make it particularly useful...

When the index's three-month moving average and "diffusion indicator" – a measure of how widespread monthly index changes are across the 85 indicators – fall to less than -0.70 and -0.35, respectively, it signals that a period of economic contraction is likely ahead.

The latest readings are negative, though still above these triggers (-0.25 and -0.23, respectively). If the diffusion indicator declines another 0.15 points like it did in September, it'll denote economic contraction for the first time in four years.

A year ago, both indicators were much higher... at +0.12 and +0.11, respectively.

I'm seeing similar warnings for the European economy...

In November, the European Commission released its Economic Forecast for 2020, acknowledging that both the European and world economies have weakened over the past year. More ominously, the commission said that "economic activity now looks set to slow down in a number of Member States, which at first appeared immune."

The report also comes to two other important conclusions (emphasis added in bold):

The fact that growth is no longer expected to rebound meaningfully in the next two years is a major shift compared to previous forecasts and is based on the assessment that many features of the global slowdown will be persistent.

China's economy is set for a structural shift to lower growth. The recent slowdown in emerging market economies amid trade tensions, tighter financing conditions and low commodity prices also now appears unlikely to be followed by a swift rebound.

In short, the global economy is weak and any shock – like another breakdown in U.S.-China trade relations, war in the Middle East, large bank failure, etc. – could quickly turn into an international crisis.

Keep in mind that 40% of the revenue earned by the S&P 500 Index – some of the largest companies in the world – is earned beyond the U.S., primarily in Europe and China.

In other words, expect any sudden downturn overseas to have an immediate impact on U.S. companies and financial markets.

Warning No. 2: Years of commodity overproduction is disastrous when economic crisis erupts...

The Great War (1914 to 1918) sparked an economic boom for American farmers that extended well beyond meeting Belgium's food supply.

Demand for U.S. agricultural products soared during the war as all of Europe could no longer produce enough food to sustain its population.

To accommodate the rising demand, the U.S. government created the federal land bank program to provide long-term loans for farm expansion. And expand they did... an estimated 40 million acres of land across the country was converted to agricultural production.

Once the war ended and European farming recovered, America's excess supply was no longer needed. But heavy debts taken on years earlier to expand operations made cutting back problematic.

So American farmers kept on producing and muddling along.

Key point: Cyclical industries like agriculture depend on boom times arriving every few years. The surplus profits enable operators to pay down debt and build cash reserves they'll need to survive the inevitable busts.

It's simple: No boom times, no cushion.

But boom times never materialized during the 1920s for farmers. Consequently, they lacked the means to pay down debt and build cash reserves.

This proved disastrous once the global economy tanked in late 1929... Over the next year, the prices of many commodities were cut in half, causing farm incomes and land values to plunge, and bankruptcies to spike from less than 2.5 per 10,000 farms, to almost 15.

Today, this same dynamic is once again playing out, but on a far greater scale.

The entire commodities complex – energy, metals and grains – has been muddling along for eight years in the absence of a boom.

You can see this playing out in the Commodity Research Bureau Index ("CRB"), which tracks 19 different commodities, including crude oil, natural gas, corn, and copper.

The CRB readings have been below the depths of the Great Recession for four straight years...

Corn, for instance, has persistently traded near or below its cost of production ($4 per bushel), enabling growers to just get by. Same story in the entire energy complex... Oil and gas prices have persisted for years near their cost of production.

What was true in Hoover's day is also true today – heavy debt levels make it difficult to cut production. This morning, the Wall Street Journal reported that it's unclear how North American oil and gas companies will pay back more than $200 billion of debt maturing over the next four years, including $40 billion due this year.

More concerning, the lack of a sustained boom since 2011 means commodity operators haven't had the opportunity to pay down debt and build the reserves they'll need to survive the next bust.

Many commodity producers are likely reaching their breaking point. In late 2019, for instance, two public energy companies – Chesapeake Energy (CHK) and Carbo Ceramics (CRR) – notified shareholders that they may not be able to keep operating. Both have heavy debt levels and negative free cash flow.

When economic crisis erupted in 1929, the blow to farmers was immediate and devastating. Expect the same for commodity producers across the globe when the next one arrives.

Warning No. 3: 'New Economic Era' sentiment breeds dangerous complacency...

The "Roaring Twenties" was a period of dramatic change in America. The shift from manual labor to mechanization, and from steam power to electricity, fueled rapid manufacturing growth and productivity across the country.

For the first time, more people lived in cities than on farms, and the nation's wealth doubled between 1920 and 1929.

Opportunity and optimism were in great abundance, giving rise to the notion the country had entered a "new economic era."

Hoover writes there was "the illusion that the economic system was thus completely immune from financial crises."

The source of the illusion was the Federal Reserve system, created in 1913 to help the government manage the occasional economic busts that often led to bank runs.

As Hoover recalls, the Fed's founders had expressed beliefs like...

Never again can panic come to the American people... Business men can now proceed in perfect confidence... [and] bankers, accepting this illusion, neglected many of their own responsibilities, [such as properly underwriting sound loans].

Between 1929 and 1933, depositors lost $1.3 billion from bank failures as the dream of a new economic era was shattered.

Clearly there was no new "economic era."

Last June, in a memo titled This Time It's Different, Howard Marks eloquently summarized the nine points driving today's irrational "new era" sentiment:

There doesn't have to be a recession.

Continuous quantitative easing can lead to permanent prosperity.

Federal deficits can grow substantially larger without becoming problematic.

National debt isn't worrisome.

We can have economic strength without inflation.

Interest rates can remain "lower for longer."

The inverted yield curve needn't have negative implications.

Companies and stocks can thrive even in the absence of profits.

Growth investing can continue to outperform value investing in perpetuity.

What do all the theories propounded above have in common? That's easy: they're optimistic. Each one provides an explanation of why things should go well in the future, in ways that didn't always go well in the past.

In recent years, the U.S. has simultaneously experienced economic growth, low inflation, expanding deficits and debt, low interest rates and rising financial markets. It's important to recognize that these things are essentially incompatible. They generally haven't co-existed historically, and it's not prudent to assume they will do so in the future.

It's hard to overstate the importance of those last two sentences.

To assume the nine conditions stated above continue indefinitely is a sucker's bet that ignores one of the few constants in the investing world – reversion to the mean.

Recessions will happen. Interest rates won't stay near zero forever. And companies incapable of generating profits won't thrive indefinitely.

Downturns always exploit the weakest links first. Ninety years ago, that included banks and farmers.

Today, the weakest links are the countless businesses, including commodity producers and their service providers, that have loaded up on inexpensive debt and failed to prepare for this eventual normalization.

You've heard our Stansberry's Credit Opportunities co-editors Mike DiBiase and Bill McGilton talk about this in particular here in the Digest.

According to the latest Dun & Bradstreet U.S. Overall Business Health Index report (October), that normalization may already be underway...

During October, the U.S. Overall Business Health Index, fell further below the 50% dividing line [to 49.7%] indicating that businesses are recording even higher risk levels of payment difficulty over the next six months than at any time since October 2013... The index continues to be weighed down by the Commercial Credit Score which has fallen to an over eight-year low.

The most important takeaway from today's essay is this...

No one knows when the next economic crisis will erupt of course. But if it happens while the three conditions just detailed are present – a global economy susceptible to contagion, persistent commodity overproduction, and a false sense of security – there's a good chance recession will last far longer, and be much more painful, than most can imagine.

Just like ahead of the Great Depression.

Which raises the question: What should you do about it?

Well, in the 1930s, with banks failing and prices collapsing, Hoover noted: "foreigners, showing their fear that we would not hold to the gold standard, began to withdraw gold from us. Our citizens began hoarding currency and gold."

Today, holding cash (not in a bank account) and gold bullion, or bars, makes sense as well...

Here's why... You don't buy a life insurance policy after finding out you're terminally ill. You get it when you're healthy.

That's the same way to think about accumulating cash and gold you can hold in your hand. You're buying economic catastrophe insurance you hope you'll never need.

My own precious metals holdings include fractional gold American Eagles...

These are the official gold coins in the U.S.

They're similar in every way to the standard 1-ounce ("oz.") version, just smaller (1/2 oz., 1/4 oz. and 1/10 oz.). A 1 oz. American Eagle is worth about $1,600 today. The 1/2 oz., 1/4 oz., and 1/10 oz. versions are respectively worth about $800, $400, and $170.

Though we're not on gold standard like we were ahead of the Great Depression, I've decided to own gold as a "chaos hedge," for two primary reasons, neither of which I hope ever happens...

First, if I ever had to quickly evacuate, a pocket full of 1 oz. and fractional gold eagles allows me to transport a substantial amount of wealth wherever I go, without anybody else having a clue. No digital footprints or anything else...

Second, if the economy ever gets so bad that gold becomes a currency again, owning smaller denominations provides me greater liquidation flexibility. For example, if I needed to exchange gold for something worth $400, I could use a 1/4 oz. gold eagle rather than liquidating a much more valuable 1 oz. eagle.

Gold stocks are also part of my economic catastrophe insurance policy...

I could care less what the share prices of these gold stocks do on a daily basis. I own them for one reason, they'll soar in price if gold takes off, as I believe it would during a major economic crisis.

In Extreme Value, the newsletter that Dan Ferris and I write, we hold two stocks in our model portfolio that are ideal for this purpose.

These companies own some of the most valuable precious metals assets on the planet. And they're capable of generating strong cash flow, which minimizes their downside.

On the other hand, both of these stocks are likely to soar if gold does. Remember, when the price of gold shoots higher, gold mining projects that have been dormant for years suddenly get a new lease on life.

Their values can suddenly rise hundreds of percent as economic feasibility improves, financing is secured, and marketability increases. Both gold stocks in our portfolio provide exposure to this kind of explosive upside.

In short, you get the best of both worlds: downside protection from durable, high-quality, cash-gushing assets, plus incredible leverage to an upswing in gold.

Businesses with both of these attributes are rare. That's why Dan calls one of them "The Hands-Down, No. 1 Pick of My Career."

To learn more about these two stocks and a subscription to Extreme Value, click here right now... Because while history doesn't exactly repeat itself, it often rhymes.

And the warning signs for the next Great Depression are in our sights today.

New 52-week highs (as of 12/31/19): Bristol-Myers Squibb (BMY), British Land (BTLCY), CBRE Group (CBRE), JPMorgan Chase (JPM), New Pacific Metals (NUPMF), Osisko Mining (OBNNF), Flutter Entertainment (PDYPY), Sea Limited (SE), and ProShares Ultra Financials Fund (UYG).

In today's mailbag, one Alliance subscriber writes in with a thank-you note... As 2020 gets going, what are your thoughts? Email us your comments and questions all year long at feedback@stansberryresearch.com.

"This is why I love Stansberry. Dan Ferris has adopted the use of trailing stops on value positions. By changing his mind on his long-standing opposition to placing stops on value positions, this demonstrates to me that advice is supported by data, not dogma. When data and reason prevail over ego among the smartest folks in investment analysis, subscribers win. Thank you again for your intellectual honesty. I wonder how we might spread that trait into politics and journalism?" – Stansberry Alliance subscriber Bill W.

Regards,

Mike Barrett
Orlando, Florida
January 2, 2020